Auditing and Investigations R.K 05 - 05 - 2006 DR Maungu
Auditing and Investigations R.K 05 - 05 - 2006 DR Maungu
Auditing and Investigations R.K 05 - 05 - 2006 DR Maungu
SUBJECT NO. 17
Revision Kit
STRATHMORE UNIVERSITY
DISTANCE LEARNING CENTRE
Email: [email protected]
Copyright
ALL RIGHTS RESERVED. No part of this publication may be
reproduced, stored in a retrieval system or transmitted in any form or by
any means, electronic, mechanical, photocopying, recording or otherwise
without the prior written permission of the copyright owner. This
publication may not be lent, resold, hired or otherwise disposed of by any
way of trade without the prior written consent of the copyright owner.
THE REGISTERED TRUSTEES STRATHMORE EDUCATION
TRUST 1992
Acknowledgment
ii
ACKNOWLEDGMENT
We gratefully acknowledge permission to quote from the past
examination papers of the following bodies: Kenya Accountants and
Secretaries National Examination Board (KASNEB); Chartered
Institute of Management Accountants (CIMA); Association of
Chartered Certified Accountants (ACCA).
We would also like to extend our sincere gratitude and deep
appreciation to Dr. Benedict Maungu for generously giving his time,
expertise valuable contribution and skilfully co-ordinated the detailed
effort of reviewing this revision -kit.
He holds the following academic honours, Bachelor of Medicine
and Bachelor of Surgery (MBChB), University of Nairobi and
CPA (K). He is a lecturer at Strathmore University, School of
Accountancy. He has generously given his time and expertise and
skilfully co-ordinated the detailed effort of reviewing this revision kit.
iii
CONTENTS
ACKNOWLEDGMENT........................................................................ii
PART I: INTRODUCTION.................................................................iv
Approach to Examinations....................................................................v
SYLLABUS.........................................................................................vi
PAPER NO. 17. AUDITING AND INVESTIGATIONS....................vi
Topical Guide to Past Paper Questions..............................................viii
PART II: PAST PAPER QUESTIONS AND ANSWERS..................1
QUESTIONS PAST PAPERS............................................................1
ANSWERS PAST PAPERS.............................................................47
PART III COMPREHENSIVE MOCK EXAMINATION............162
QUESTIONS - MOCKS...................................................................162
ANSWERS MOCKS.....................................................................182
PART IV: REVISION QUESTIONS AND ANSWERS.................243
QUESTIONS.....................................................................................243
ANSWERS........................................................................................254
iv
Introduction
PART I: INTRODUCTION
Do the MOCK papers in part III under exam conditions and then
check the solutions provided to assess their success in tackling the
questions
vi
Introduction
APPROACH TO EXAMINATIONS
Experience in marking auditing examinations suggests that failure to
answer all the questions and poor expression are every bit as frequent
causes of failure as lack of knowledge. Lack of knowledge necessitates
more learning, but the two other problems may not be so easily solved.
They are essentially inter-related, and while not exclusive to auditing
they are perhaps more apparent in this subject. So the following ideas
may help you to give your best performance on the day.
Remember that you gain most marks by citing the main concepts in
response to a question. You gain little by going into immense detail. So
it follows that you can score relatively the most marks in the first few
minutes of your answer attempts provided that you know the main
concepts. And if you do not, then the examiner will not be impressed by
a profusion of irrelevant detail. Indeed he may become annoyed, and
this may cloud his view as to the rest of your paper. Examiners are only
human (nearly!) remember.
To ensure that you have the opportunity of scoring on all the questions
you must answer all of them! Even if you can produce four perfect
answers five adequate ones will normally score better. And perfect
auditing answers are very rare. So it is essential to divide your time up
equally between the questions leaving a bit over for reading and review
time. Be ruthless about the cut-off time. For if you creep over on your
first few answers you risk having too little time for even the main
concepts in your final answer.
Auditing answers require planning and a structure. Without this,
expression will invariably be poor. And the introduction of unnecessary
detail often makes matters worse. So concentrate on quality rather than
quantity. And quality must apply to both your written English, which
should be a professional style (it is after all a professional examination),
and to your handwriting. Examiners try to decipher the indecipherable
(usually), but the temptation to put a large cross through illegible work
is very strong at the end of a long marking session.
Answer the question is an obvious point, which applies to any
examination. But it is amazing how many candidates do not. So you
must read the question carefully perhaps once quickly through the
complete paper to gather the main topics from each question, and then
again in more detail to ensure that you have a proper understanding
before you commence your answers. Then give your answer in the
Approach to Examinations
vii
form that is required. For example, if a letter is asked for, give your
answer in letter format. You will lose marks for an essay.
Examiners regretfully do not always supply perfect questions so if you
find one that is ambiguous, choose another one if possible; but if not
possible then state your assumptions and proceed logically from there.
Even if the examiner disagrees with your assumptions, he should award
marks for a logical, practical exposure. But he may not, just as he may
not award marks if you are highly critical (of his opinions) in a question
involving a controversial issue. So I would avoid such questions also,
but if you cannot avoid them, ensure that you put both sides of the
debate, and do not state your opinions in too forceful a manner. Where
you are expressing your own opinion (to which you are perfectly
entitled), ensure that this is distinguished in your answer from where
you cite the opinions of others, or rely on recognized publications.
The auditing syllabus is large. And becomes larger with each new
Auditing Standard and Accounting Statement. Questions are now being
written much more imaginatively than in the past, and often test several
aspects of the syllabus in just one question. An analysis of past papers
will reveal certain aspects of the syllabus which examiners (rightly)
concentrate upon (for example, stock, debtors and computers). While it
is highly dangerous to question spot to the extent that your preparation
for the examination involves only five topics, it is common sense to pay
particular attention to those topics that are frequently examined.
Good luck!
viii
Syllabus
SYLLABUS
PAPER NO. 17. AUDITING AND INVESTIGATIONS
OBJECTIVE
To ensure that the candidate has competence in the auditing of public
and private institutions and to carry out audit investigations.
SPECIFIC OBJECTIVES
A candidate who passes this subject should be able to:
Syllabus
ix
Accounting Reports
Audit Investigations
July 2000
IFRS adoption
Audit strategy
Review and evaluation of
audit work
Impact and processing
controls in a
computerized
environment
Investigations and review
of financial statements
Fraud investigations
Audit responsibilities in a
receivership
Controls in a
computerized auditing
environment
Professional ethics,
illegal payments
Fraud, ethics, review of
financial statements
Insurance claims
Dec 2000
TOPIC
2
3
4
QUESTION
ANSWER
xi
Syllabus
SITTING QN
TOPIC
QUESTION
ANSWER
June 2001 1
Management
letters/Internal control
Provision, impairment of
assets
Leasehold assets
Subsequent events
Dec 2001
Corporate
governance/audit
committees
3
4
Purchase of computer
systems and impact of
computerization on
auditing
Audit, risk, ethics and
opinion shopping
June 2002 1
Internal control
Going concern
Investigations
Advantages of
computerization
Topical issues and
auditor negligence
Dec 2002
1
2
3
xii
QN
TOPIC
SITTING
4
5
June 2003 1
Dec 2003
Inventory valuation,
depreciation, contingent
liabilities
Topical issues and
developments
Prospective financial
information
Management letters
Analytical review
Revenue recognition
Internal controls
Audit planning
Internal controls
Provisions
Creative/aggressive
accounting
Fraud and ethical
considerations
QUESTION
ANSWER
xiii
Syllabus
June
2004
Dec
2004
June
2005
Audit of stocks
Fraud
1
2
Internal controls in a
network environment
Audit planning
Going concern
4
5
Corporate
governance/auditor
negligence
Current issues
Audit planning
Assurance engagements
Prospective financial
information and fraud
Related party transactions,
Group audits
Internal audit
Computerised auditing
Assurance engagements
Substantive procedures
Audit planning
Dec
2005
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Questions
Questions
Required:
As the investigating accountant, detail those matters which you
would pay particular attention to in carrying out your review.
(Total: 20 marks)
Questions
QUESTION TWO
The following quotations are extracted from the International
standards of auditing in a computer information systems
environment.
1.
Questions
Answers
10
11
12
Answers
Ltd.s balance sheet as a fixed asset. The maintenance and running costs
of the pool have been charged to the profit and loss account as promotion
and selling costs.
Several large payments have been made to unidentified agents and
described as commissions in respect of obtaining building contracts.
Most of these payments have been made in cash, some of which were in
foreign currencies, however, some payments have been made by cheque.
Enquiries relating to the payee of the cheques have revealed that they are
in the name of a nominee and the beneficiary cannot be identified. There
is no supporting documentation for any of the payments. The finance
director of Rural and Urban Housing Ltd. Has said that such
commissions are common practice and the agents represent valuable
contracts whose identity must be kept confidential as otherwise Rural and
Urban Housing Ltd.s competitors would be able to poach work from
them.
Required:
As the engagement partner for the audit of Rural and Urban Housing
Ltd., discuss the matters you would consider including any further
inquiries you would make, in determining the appropriate treatment of:
a) job spoo-1;
(7 marks)
b) the payments of the commissions
(8 marks)
(Total:
15 marks)
QUESTION THREE
Commercial Sales Ltd. was a growth-oriented company that was
dominated by its managing director, Mr. A Chongo. The company sold
quantity music systems direct to the public. A large number of sales
person were employed on a commission only basis. The music systems
were sent to the sales agents who then sold them direct to the public
using telephones sales techniques. The music systems were sent to the
sales agents on a sale or return basis and commercial sales ltd. recognized
the sale of the equipment when it was received by the sales agents. Any
returns of the music systems were treated as repurchases in the period
concerned.
The company enjoyed a tremendous growth record. The main reasons for
this expansion were as follows:
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14
Answers
report
on
the
year
end
financial
statements.
(4 marks)
d) Discuss whether you think that the auditor is guilty of professional
negligence in not detecting the fraud.
(5 marks)
(Total: 20 marks)
QUESTION FOUR
Omega Furniture Ltd. is an audit client of Omega firm. It manufactures
household furniture. It has a year-end of 31 December. On 13 June
2000, a fire destroyed the companys factory complex, which included
the area used for storing raw materials. The fire was caused by an
electrical fault. The factory has now been rebuilt and the company
commenced trading again in November 2000.
The finance director of Omega Furniture Ltd. produces monthly
management accounts; in these stocks and cost of sales are estimated,
based on sales figures less assumed margins. On 321 March and 30
September, the company conducts full stocktakes for its own purposes in
addition to is year end stock count. The results of these stock counts are
compared with the management accounts for March and September and
adjustments are made to reflect the physical stock quantities and their
appropriate values.
The finance director has contacted your firm to provide a certificate in
support of his claim for loss of profits and loss of stocks arising as a
result of the fire.
Required:
a)
State what information you would seek and what procedures you
would perform to reach an opinion on the companys claim for loss of
profits and loss of stocks.
(12 marks)
b) Assuming you obtain all the information you require, draft your
special report. Give brief reasons for the form of wording you have
adopted.
(8 marks)
(Total:
20 marks)
15
QUESTION FIVE
In an attempt to improve Corporate Governance of companies in Kenya
banks and listed companies are now required to have audit committees.
Explain the composition and the role of audit committees and offer
suggestions as to how their role can be strengthened.
(Total: 20 marks)
Answers
16
17
(Total:
20
marks)
QUESTION TWO
You are the auditor of Nairobi Motor spares ltd, a private company which
wholesales parts for cars and vans. You have completed the fieldwork for
the year ended 30 April 2001 and have identified the following three
outstanding issues.
1.
3.
Stock has risen substantially over the 12 months to 30 April 2001 and
the client is unable to provide a satisfactory overall explanation. An
analysis of the increase would require an extensive line-by-line
review, which the client is unwilling to do because of the number of
lines in stock. The managing director suggests that bulk-buying
opportunities offered at attractive prices account for a good part of the
stock increase. The clients computer system generates a document
called an "old stock listing" which the audit staff has used to assess
stock provisions. It is produced annually at the year-end by a special
software routine. The old stock listing identifies only those stock
lines not moving at all during the last six months of the year and
Answers
18
shows a 25% increase on the previous year in the total value of such
items. No further ageing information is produced. The client has
based the stock provision on items included in the "old stock listing".
Required:
In respect of each of the above three issues, state what further evidence
you would seek in order to reach a conclusion upon the accounting
treatment to be adopted in the financial statements of Nairobi Motor
Spares ltd at 30 April 2001.
(Total: 20 marks)
QUESTION THREE
You are the auditor of a company whose year-end was 31 March 2001.
The directors have decided to obtain a professional valuation of all the
freehold and leasehold properties as at 31 March 2001 and to reflect this
valuation in the accounts to 31 March
2001.
The following points are brought to your attention:
1. Depreciation has never been provided on freehold and long leasehold
properties
2. One of the properties is wholly let out to third parties, and the directors
intend to dispose of this property as soon as possible.
Required:
Set out the matters which, as a result of the property valuation, should be
taken in consideration during the preparation of the accounts to 31 March
2001 and the disclosures, which should be made in the accounts for that
year.
(Total: 20 marks)
QUESTION FOUR
You are the auditor of a listed (quoted) company with diversified interests
mainly of an industrial nature. One subsidiary, however, acquired on the
first day of the financial year, is engaged in banking. The finance
director has asked you to advise him as to the manner in which the
banking subsidiary should be treated in the group accounts.
Required:
19
Write a formal letter to the finance director setting out the legal and
accounting standards requirements appropriate to these circumstances
(Total: 20 marks)
QUESTION FIVE
"The management letter is a form of report by external auditors to the
management. This report which in some respects is a report on the ability
and effectiveness of management is useful to shareholders as the financial
statements and should be distributed to the shareholders not just to
management themselves."
Required:
Discuss the merits and demerits of this proposition. How does it compare
to the current practice?
(Total: 20 marks)
Answers
20
21
As the engagement partner for the audit of Rural and Urban Housing Ltd,
discuss the matters you would consider including any further inquiries
you would make in determining the appropriate treatment of:
a) Job Spoo 1
(7 marks)
b) The payments of the commissions
(8 marks)
(Total:
15 marks)
QUESTION TWO
Jos Enterprises ltd went into creditors' voluntary liquidation in February
2001 with total assets estimated to realize Sh 87 million and total
estimated liabilities of Sh 10 million. The liquidator has recently
commenced proceedings against the company's auditors for alleged
negligence, and the auditor's advocates have approached you as an
independent expert to advise on the auditor's position.
The last audited financial statements were for the period to 30 June 2000
and were signed by the auditors on 16 September 2000 without
qualification. It is alleged that the financial statements, which showed
fixed assets and deferred expenditure of Sh 22,425,000, current assets of
Sh 84,410,000 and total liabilities of Sh 91,540,000, contained the
following inaccuracies and omissions.
1. Improvements to lease hold premises, costing Sh 6,210,000 in July
1998, had been capitalized and were being amortized over the life of
the 25-year lease. These premises were vacated in October 2000 and
placed on the market. No tenant could be found and the liquidator
ultimately surrendered the lease to the landlord.
2. Deferred expenditure in the balance sheet of Sh3, 910,000 represented
the balance of pure and applied research and development costs
incurred two years previously. It was to have been written off over the
following eight years, being the remaining period estimated by the
directors over which the relevant product was expected to be sold,
although production of that product ceases in July 2000.
3. Credit notes totaling Sh 1,955,000 were raised in August, September
and October 2000 in respect of sales of faulty goods to customers,
which had been included in debtors at 30 June 2000 against which no
provision had been made.
22
Answers
20
Note:
In your answer, you are to assume that all the six matters were or would
have been material to the company's financial statements for the year
ended 30 June 2000.
QUESTION THREE
You are the auditor of LF Ltd, a large company which has for some years
operated a defined benefit self-administered pension scheme for all
employees. You are also the auditor of the pension scheme. The scheme
carries out an actuarial valuation once every five years.
23
24
Answers
a) i. Discuss the matters Mr. PJ Shah should take into account when
deciding to purchase a system such as described above.
(6 marks)
ii. Discuss the major effects the computerization of PJ Manufacturing
ltd accounting system will have on the planning of the audit for the
year to 30 September 2002.
(7 marks)
(b) Auditors of firms of all sizes, particularly those of large companies,
have to be aware of the changes that advances in information
technology are having on the audit environment.
Required:
Describe how developments in information technology are currently
affecting auditing and their possible future impact.
(7 marks)
(Total: 20
marks)
QUESTION FIVE
Twenty Second Century Ltd, a large company was founded and
controlled by Mr. J.Presscot. The principal business of the company was
to develop derelict land in city and town centers into office
accommodation. In 1999, Kenya Revenue Authority became suspicious
of the nature of the operations being carried out by the company and an
investigation into its affairs commenced. The resultant report stated that
the company's internal controls were weak and non-existent in many
cases. The investigators found payments to unknown persons and
fictious consultancy firms. In addition Mr. Prescott had maintained a
secret expense account that was used to disburse funds to himself. The
board of directors of Twenty Second Century Ltd did not know of the
existence of this account. This expense account was maintained by the
partner firm of accountants responsible for the audit of the company. The
auditors were heavily criticized in the report of the investigators.
The firm of auditors A to Z & Co. had an aggressive marketing strategy
and had increased its audit fees by 100% in two years. The audit firm
had accepted the appointment in 1997 after the previous auditors had
been dismissed. The audit report for the year ended 1996 had been
heavily qualified by the previous auditors on the grounds of poor internal
control and lack of audit evidence. Mr. J.Presscot has approached several
firms of auditors in order to ascertain whether they would qualify the
25
Answers
26
27
QUESTION TWO
(a) List the factors and explain reasons why these factors may indicate
that a company may not be going concern
(b) Describe any further investigations you would carry out to decide:
(i) Whether the company is a going concern and
(ii) Whether it has a reasonable chance of recovering from the going
concern problems.
Your answer should include details of checks you would carry out in
verifying the company's profit and cash flow fore casts.
(10 marks)
(Total 20
marks)
QUESTION THREE
John Mwangi has recently asked your firm's advice on whether to
purchase Nathoo Merchants Ltd, which is a small builders' supply
merchant. John Mwangi has previously been the proprietor of a small
do-it-yourself business (which is a similar trade to the builders' supply
merchant, but sells mainly to individuals), and he has recently been left a
substantial sum of money on the death of his father.
Natho Merchants ltd sells:
1. Paint and decorating material
2. Hand tools and small electrical tools (for instance electric drills).
3. Electrical fittings, and
4. Building materials (bricks, wood, sand and cement).
The current owner of Nathoo Merchants ltd is retiring and is proposing to
sell his business to John Mwangi. Nathoo Merchants ltd is financed by
equity, bank loans and overdrafts. Their are no current accounts or loan
accounts between the directors and the company.
The audited accounts of Nathoo Merchants ltd for the three years ended
30 April are available and John Mwangi has asked you to carry out an
investigation into whether the accounts are reliable. The accounts of
Nathoo Merchants ltd have been prepared by the auditor. From your
knowledge of the auditor's reputation and the weakness in the system of
28
Answers
29
30
Answers
(1 mark)
20 marks
31
(Total:
Answers
32
33
A check of current controls in the wages system has revealed that the
company has failed to institute controls to prevent these types of fraud
recurring. So the audit programme requires extensive substantive
procedures to be carried out to ensure that recorded wages transitions
have not been mis-stated by similar frauds taking place in the current
year.
The existence of employees at the head office site can be verified by
physical inspection. From a cost effectiveness point of view, only a small
sample of plantations will be visited. The audit manager has asked you to
consider the audit procedures you would carry out to obtain sufficient and
appropriate evidence of the existence of employees at the plantations not
visited by the audit staff.
The audit manager has explained that "unclaimed wages" (in part (c)
below) arise when employees are not present to collect their wages at the
time of payment. The unclaimed wage packets are given to the cashier
who records their details in the unclaimed wages book and is responsible
for their custody. Any employees who have not received his/her wage
packet at the payout can obtain it from the cashier. You have ascertained
that there is no system of checking the operation of the unclaimed wages
system by a person independent of the cashier and the wages department.
You are required to describe:
(a) How you would verify that employees are not paid before they have
commenced employment or after they have left (a starters and leavers
test).
(5marks)
(b) The audit procedures you would carry out in connection with
attending a payout of wages in cash to the employees.
(5 marks)
(c) The substantive checks of transactions you would carry out on the
unclaimed wages system.
(5 marks)
(d) The evidence you would obtain to verify the existence of employees
whose wages are paid directly into their bank accounts.
(5 marks)
(Total:
20 marks)
QUESTION TWO
Answers
34
You are the audit manager on the audit of Super Furniture Ltd a company
which manufactures office and household furniture. The financial yearend of the company is 30 June 2002 and you took charge of the audit
assignment on 20 august 2002 after the resignation of the previous audit
manager.
The following are extracts from the audit-planning memorandum.
(a) Shareholdings
Currently all shares are held by the directors. A takeover offer has
been received from Dominant Furniture Ltd, a listed company to buy
51% of the equity shares in Super Furniture Ltd. Negotiations are still
under way.
(b) Materialiality
The materiality level has been set at Sh 1.5 million.
While reviewing the audit working papers for the year ended 30 June
2002, you find the following notes prepared by the senior in charge of the
audit.
2002
Sh.
000
2001
Sh. 000
1. Sundry accruals
3,774
2. Provision of leave pay
1800
3. Provision for major maintenance
7954
4. Provision for legal costs
480
5. Provision for losses on insurance
claims
6. Provision for credit notes
750
7. Provision for management and 1,800
provisions
Total sundry accruals and provisions 16,558
5,028
6,180
12,000
1,050
Notes
1. Sundry accruals
750
2,245
27,253
35
2.
3.
4.
Answers
36
6.
37
38
Answers
39
3. Contingent liability
The company is being sued for Sh 4 billion by the Ministry of
Construction for defective work on a recently completed road. The
company maintains that it met the ministry's construction's specifications
and that it is the Ministry's engineers who are at fault in drawing up the
specifications. AZ ltd maintains that it has no case to answer, that the
possibility of loss is remote and that the claim need not be disclosed as a
contingent liability.
An investigative journalist has recently published an article suggesting
that other roads constructed by the company exhibit similar faults. The
chief executive officer has admitted that the company's road building
techniques are under investigation by the Ministry of construction. If the
company were to lose the case, its future as a going concern would be
threatened.
Required:
Explain the effect of each of the three matters, namely: inventory
valuation, depreciation and contingent liability (i) on the financial
statements and (ii) if the company were to refuse to amend the financial
statements on the auditor's report.
(Total: 20 marks)
QUESTION FIVE
(a)
Answers
40
(ii)
41
QUESTION TWO
You are the auditor senior for Kenya Computer Sales Ltd., a distributor of
microcomputers, and have just completed the interim audit. When you
42
Answers
and your staff were auditing the accounting records, systems and
controls, you recorded in your files the following information:
1. The credit limits for four customers of Kenya Computer Sales Ltd.
had been substantially exceeded and new customers in the last twelve
months had not been allocated credit limits.
2. When testing a sample of fifteen purchase invoices, you noted that
one purchase invoice had been posted twice to the purchases ledger
by mistake and two other purchase invoices could not be traced.
3. The results of a stock take conducted at the half year revealed that
some microcomputers supposed to be in stock were missing and that
other microcomputers which had been returned by customers were in
stock but had not been recorded as having been returned. A few of
the missing microcomputers have been traced to directors and staff
who have borrowed them for personal use at home.
4. Leasing agreement for microcomputers offered by Kenya Computers
Sales Ltd. to its customers have been queried by the Kenya Revenue
Authority (KRA) who are not satisfied that the terms of the
agreement which give the customer the right to purchase the
equipment at a future date, qualify them as leases as opposed to hire
purchase agreements. These agreements have been in use for a
number of years and were vetted by your firm.
Required:
(a) Draft a management letter addressed to the board of directors
commenting on the weaknesses you have discovered, the risks
arising from those weaknesses and your recommendations for
improvements.
(14 marks)
(b) Comment on any significant impact these matters may have on your
year-end audit work.
(6
marks)
(Total: 20
marks)
QUESTION THREE
Panafrican Electrical Ltd. manufactures a small range of standard
electrical switches, sockets and plugs, and supplies them to electrical
43
(b)
(Total: 20 marks)
QUESTION FOUR
Mal Engineers Ltd. are aircraft service engineers with a current annual
turnover of approximately Sh.96,000,000. Generally, customers are
invoiced for maintenance work at the time that service is provided
although the company offers their customers a three-year service contract
on payment of a non-refundable fixed fee at the beginning of the contract.
You have been appointed as the auditor, your predecessors having
resigned after completing the audit for the year ended 30 September
2002. The previous auditors report was unqualified. You have
commenced the planning of the audit of the financial statements for the
year ending 30 September 2003 and have found that, on the basis that
44
Answers
payment for the three year service contract are non refundable, the
directors have in previous years taken credit for all such income at the
time that the contract is entered into. The management accounts for the
year ended 30 September 2002 was Sh.5,760,000 and income from
service contracts entered into during the year amounted to Sh.25,800,000.
Required:
(a) Your reservations, if any, on the accounting treatment of the income
from the three-year service contracts.
(b) Your recommended treatment of such income together with the
disclosures you consider necessary, in order for the financial
statements to show a true and fair view.
(12
marks)
(Total:
20 marks)
QUESTION FIVE
The Chief Executive of Modern Supermarkets Ltd., a large supermarket
chain, is concerned about the controls in the companys computerized
purchases ledger by the purchases accounting department, and the
computer automatically raises the cheque when the invoice is due for
payment. The relevant information with regard to payment by cheque is
as follows:
1. For payment under Sh.5,000 per printed cheques are used and no
further authorization of the cheque is required, as the authorized
signature is included in the preprinted cheque.
2. For payments above Sh.5,000 but below Sh.50,000 an authorized
person is required to initial the cheque.
3. For payments over Sh.50,0000 an authorized signatory must sing the
cheque.
Required:
Describe the controls which should be in operation to prevent fraud and
error in the companys purchases system in relation to:
45
(a) Controls to ensure that only authorized purchase invoices and credit
notes are posted to the purchase ledger.
(b) Controls over the addition, amendment and deletion of suppliers from
the suppliers list and ensuring that only authorized suppliers are on
the standing data file.
(c) Controls over the cheque payments and the custody of the cheques.
(8
marks)
(Total: 20 marks)
Answers
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47
Answers
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Required:
Describe a suitable system of interest control over credit sales. Do not
deal with the aspects dealt with in (i) and (ii) above.
(Total: 20
marks)
QUESTION THREE
You are the new audit manager on the audit of Tex Ltd., a company
which manufactures office and household furniture. The financial year
end of the company is 30 June and you took charge of the audit on 20
August 2003 after the resignation of the previous audit manager.
The following are extracts from the audit planning memorandum:
1. Shareholding:
Currently all shares are held by the directors. A takeover offer has
been received from Malt Ltd. a listed company to buy 51% of equity
shares of Tex ltd. Takeover negotiations are already under way.
2. Materiality
The materiality level has been set at Sh.2,500,000. While reviewing
the audit work papers for the year ended 30 June 2003, you find the
following notes prepared by the senior in charge of the audit:
Sundry accruals and provisions
2003
Sh.
2002
Sh.
Sundry accruals
6,290,010
8,382,530
Provision for leave allowances
3,002,850
10,302,710
Provision for major maintenance
13,257,410
20,000,000
22,550,270
38,685,240
Notes:
(a) Sundry accruals
For a full list of accruals see working paper H2.1. Supporting
documentation has been seen for all accrued amounts over
Sh.100,000, totaling Sh.4,275,380 (68%). All accruals are for
normal expenses of the company and appear to be reasonable.
(b) Provision for leave allowances
This amount agrees with the total leave allowances due on the print
out from the salaries system. We have reviewed the controls in the
salaries system, including the computerized leave records and have
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50
Answers
companys earnings per share have been steadily declining which has
resulted in the current market process of the share being well below the
net asset value per share.
At the commencement of your final audit for the year ended 31 October
2003, you are handed price Right Wholesalers ltd. draft finical statements
for the year which show a substantial increase in net profit over the
previous year. You have ascertained that the companys method of
operation, its level of efficiency, its sakes volume, the selling and
purchase prices and the non-wholesaling revenues are relatively
unchanged compared with the previous years.
Required:
(a) List the methods which could have been used to overstate the
profits for the year
ended 31 October 2003.
(10 marks)
(b) Describe briefly, for each method in (a) above the audit procedure
which would be used to verify whether or not that method has been
used.
(10 marks)
(Total: 20
marks)
QUESTION FIVE
Your staff have recently completed the fieldwork in respect of the audit
of Craig Ltd. for the year ended 30 September 2003. You have been the
companys auditors since inception.
The entire share capital has been held by Mr. G. Craig since
incorporation. While working on the audit of your assistant discovered a
file which appeared to indicate that substantial money in respect of cash
sales had not been recorded in the accounting records and were also not
included in turnover per the companys VAT returns.
Your assistant found this quite disturbing as, in addition to the audit, your
firm assists Mr. Craig with the VAT returns and completes both the
companys tax returns and Mr. Craigs personal returns.
Mr. Craig admitted to your assistant that he has for some years followed
the practice of pocketing most of the cash sales of the company. Mr.
Craig was reluctant to discuss the matter in detail although he did not
make it clear that he felt that Craig Ltd. was his company and that the
51
auditors should not dig too deeply. Besides the company makes a
healthy profit and already pay too much tax.
Required:
(a) Discuss the attitude you could adopt and the action, if any, you
would take in the circumstances.
(16 marks)
(b) Explain how your answer in (a) above would differ if your firm was
doing the audit for the first time
(2 marks)
(c) Explain your response if Mr. Craig were to ask for your immediate
resignation
(2
marks)
(Total: 20
marks)
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53
Answers
54
The results of operations and the financial position of RS Ltd. for the
previous financial year as well as the current financial year are
summarized as follows:
Actual Year ended
Budget Year
31 December 2003
31 December
ended
2003
Sh. Million
Turnover
11,480
Profit before interest and tax
1,270
Profit before tax
920
Profit after tax
630
Ordinary shareholders funds
3,240
Total assets
5,500
Sh. Million
13,780
1,500
1,200
800
3,640
6,000
You are currently planning the audit for the year end 31 December 2004.
The following matters have come to your attention during your review of
last years working papers and the most recent management accounts and
during discussions with the financial director of RS Ltd.
1. MPH Ltd., the holding company of RS Ltd. is in financial difficult.
MPH Ltd. holds 50% of the ordinary shares in issue.
2. RS Ltd. also has retail outlets in Tanzania, Uganda, Ethiopia and
Sudan.
3. The managing director of RS Ltd., Mr. Peter Rush, has acquired an
interest in a national car hire business. It appears from discussions
with the financial director of RS Ltd. are encouraged to use this car
hire company at all times. Car hire expenditure is a material
component of the operating costs of RS Ltd.
4. The RS Ltd.s pension fund has a large surplus. During the current
financial year, the company has temporarily suspended its
contributions to the pension fund.
5. RS Ltd. made a loan to Mr. Peter Rush to purchase shares in the
company. The financial director intends to obtain repayment of the
loan before the financial year end and to re-advance the funds from
the RS Ltd. share trust.
6. RS Ltd. is currently involved in a dispute. A customer is alleging that
certain building supplies purchased from the company were substandard and the customer is claiming damages of Sh.50 million. RS
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Ltd. has rejected this claim. A preliminary trial date has been set for
February 2005.
During a discussion with Mr. Peter Rush he offered to supply, free of
charge, the bathroom tiles and plumbing materials for the house you are
in the process of building.
Required:
(a) Outline the potential audit risks apparent from the above matters and
state briefly the audit procedures necessary to address the risks you
have identified. Detailed audit programme steps are not required.
You simply need to set out each of the issues that will need to be
covered
by
your
audit
procedures.
(16 marks)
(b) Indicate what matters you need to consider, what steps you should
take before responding to the offer from Mr. Peter Rush. In addition,
state what you believe to be the appropriate response to Mr. Peter
Rush.
(4 marks)
(Total: 20
marks)
QUESTION THREE
Your firm is responsible for auditing the financial statements of HK
manufacturing Ltd., a privately owned incorporated business, for the year
ended 31 May 2004. The company operates from a single site. Its sales
are Sh.380 million and the profit before tax is Sh.8,360,000. There are no
inventory records so the inventory counts at the year end will be used to
value the inventory in the financial statements. As Monday 31 May 2004
is a normal working day, it has been decided that the inventory should
take place on Sunday 30 May 2004 when there is no movement of
inventory.
The company has produced the following schedule to determine the value
of inventory at 31 May 2004 from that counted on 30 May 2004.
Sh.
Value of inventory 30 May 2004
44,326,772
Add: Cost of goods received on 31 May 2004
Production ;labour on 31 May 2004
Sh.
833,644
247,760
Answers
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297,312
1,378,716
Less: Cost of goods sold on 31 May 2004
2,792,240
Value of inventory at 31 May 2004
42,913,248
The company keeps basic accounting records on a microcomputer using a
standard software package. The accounting procedures for sales,
purchases and wages comprise:
1. Dispatch notes are raised by the shipping department when the goods
are sent to customers. Sales invoices are produced from dispatch
notes. Sales invoices are input into the computer which posts them to
the accounts receivable ledger and the general ledger.
2. When goods are received, a goods received note (GRN) is prepared,
purchase invoices are matched with GRNs and purchase orders are
authorized by the chief executive officer. After the purchase invoices
have been authorized, they are input into the computer which posts
them to the accounts payable ledger and the general ledger.
3. For the wages system, the hours worked by each employee are input
into the computer which calculates the gross wage and deductions;
PAYE, NSSF, NHIF and the net pay. All employees are paid weekly.
Required:
(a) The audit procedures you should perform to verify the accuracy of
the inventory
count:
(i) Before the inventory count, and
(5 marks)
(ii) On the day of the inventory count
(5 marks)
Your answers to parts (i) and (ii) above should include details of
the matter you should record in your working papers for follow-up
at the final audit.
(b)
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inventories.
(6 marks)
(c) The substantive procedures you should perform to check the
purchases cut off at the year end.
(4 marks)
(Total: 20
marks)
QUESTION FOUR
(a)
The partner in charge of your audit firm has asked your advice on
frauds which have been detected in recent audits.
The audited financial statements of a client, Lam Trading Ltd., were
approved by shareholders at the Annual General Meeting on 3 June
2004. On 7 June 2004 the managing director of Lam Trading
discovered a petty cash fraud by the cashier. Investigation of this
fraud has revealed that it has been carried over a period of one year. It
involved the cashier making out, signing and claiming petty cash
expenses which were charged to motor vehicle expenses. No receipts
were attached to the petty cash vouchers. The managing director signs
all cheques for reimbursing the petty cash float. Lam Trading Ltd. has
sales of about Sh.160 million and the profit before tax is about Sh.12
million. The accountant has prepared the draft financial statements
for audit.
The partner in charge of the audit decided that no audit work should be
carried out on petty cash. He considered petty cash expenditure was
small, so the risks of a material error or fraud was small.
Required:
(i)
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Answers
(3 marks)
(iii) Consider whether your firm is negligent if the fraud amounted to
Sh.1,600,000
(3 marks)
(b)
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(Total:
20
marks)
QUESTION FIVE
(a)
(b)
Required:
(i) Explain two circumstances under which the partner may incur
personal liability for acting as the receiver manager of Kool Ltd.
(4 marks)
(ii) What steps should the partner take to minimize his personal
liability when acting as the receiver manager of Kool Ltd?
(4 marks)
(Total: 20
marks)
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audit of the financial statements for the year ended 30 June 2004, your
preliminary evaluation of the internal controls indicated that reliance
could be placed on the system. However, compliance tests carried out
during the audit disclosed that the system was not operating effectively.
This situation has necessitated various amendments and additions to your
original audit plan.
Required:
Describe the changes to be effected:
a) During the interim audit.
(13 marks)
b) After the end of the financial year.
marks)
(7
(Total: 20
marks)
QUESTION THREE
The International Auditing Practices Committee requires that doubts
about the going concern presumption be detected and adequately
disclosed in the financial statements and auditors reports.
Required:
a) Explain the term going concern in relation to the preparation of
financial statement.
(4 marks)
b) Describe the audit procedures the auditor should undertake in order to
obtain sufficient audit evidence to be able to form an opinion on the
going concern status of the company.
(6 marks)
c) List six factors which might cast doubt on the going concern status of
a company.
(6 marks)
d) Discuss briefly how the present responsibilities of the auditor
regarding the going concern status of company could be extended.
(4 marks)
(Total: 20
marks)
Answers
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QUESTION FOUR
a) Corporate governance has become an issue of world wide importance.
In furtherance to corporate governance, audit committees have been
established by various companies.
Required:
Explain six ways in which the establishment of an audit committee
would assist in improving the effectiveness of external audit work.
(6 marks)
b) The ban on advertising of accountancy services in Kenya is not
sustainable. Discuss.
(10 marks)
c) The auditors have a legal duty to their clients. This legal duty appears
to have, of late, been extended to cover third parties not in direct
contractual relationship with the auditors.
State specific actions an auditor or an audit firm should take to
minimise liability deriving from audit risk.
(4 marks)
(Total: 20
marks)
QUESTION FIVE
In the past, the accountancy profession has been criticised for its role in
monitoring and reporting potential corporate failure. Radical reforms
have been called for in the way the accountancy profession is regulated.
There have been calls for legislation in the following areas:
1. Auditing standards:
Auditing standards should be set and enforced independent of the
accounting profession.
2. Fraud:
Auditing firms should have a duty to detect and report fraud.
3. Non-audit services:
Auditors should not provide their clients with non-auditing services.
4. Duration of auditors appointment:
The appointment of auditors should be for a maximum period of seven
years.
Required:
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Answers
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ii)
iii)
iv)
The
client
prepared
management accounts consisting of a detailed income statement
and a balance sheet for each cost centre, from which the auditors
produced financial statements in compliance with the requirements
of the Companies Act and international financial reporting
standards (IFRSs)
The final audit work had
commenced before the client had adjusted the management
accounts for a number of substantial creditors arising from the late
invoices received from suppliers, so that the audit team had to
verify subsequent amendments to the first draft of the management
accounts.
As a result of the delays in
the preparation of final management accounts, an additional
member of staff was added to the audit team towards the end of the
audit in order to meet a deadline imposed by the client after the
final work had commenced.
As a result of past
acquisitions of businesses, four of the locations are operated as
separate subsidiaries.
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v)
The clients accounting systems are being computerized over a three
year period which commenced in 2003 and additional audit time
had arisen in the year ended 30 September 2004 as a result of the
need to ascertain and document the new systems which had been
introduced.
vi)
In view of significant
problem which had arisen in the audit for the year ended 30
September 2003, extensive substantive tests had been carried out on
the stock control system for the year ended 30 September 2004
although those tests disclosed no serious problems.
Required:
Write a letter to the Managing Director suggesting steps which the
company should take to reduce the time spent on audit work for the
current year ending 30 September 2005.
(Total: 20 marks)
QUESTION TWO
Before accepting other assurance engagements for audit clients, an
auditor should consider the impact of the proposed engagement on the
integrity and independence of the audit.
Required:
(a) Define the term assurance engagement and explain its purpose
(4 marks)
(b) Explain the engagement risk that faces a practitioner who accepts
an assurance engagement.
(4 marks)
(c) Describe the forms of audit assurance reports that a firm involved
in assurance engagements may give to minimise its assurance
engagement risk.
(6 marks)
(d) Describe the forms of audit assurance reports that a firm involved
in assurance engagements may give to minimise its assurance
engagement risk
(6 marks)
(e) Identify and explain the potential threats to the independence of a
firm involved in assurance engagements.
(6 marks)
(Total: 20 marks)
QUESTION THREE
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Answers
(a)
Define
the
term
prospective financial information and identify the main
challenge which reporting on such information poses to auditors.
(4 marks)
ii)
Summarise the procedures
that Kilonzo and Associates should carry out in order to be in a
position to report on the profit forecast for the year ending 31
December 2005.
(10
marks)
(b) The question of the auditors responsibility for the detection and
prevention of fraud is highly contentious. The past few years have
seen an increase in both the incidence and scale of corporate fraud,
while the question of third party liability has also not be conclusively
settled by case law.
Required:
Explain the procedure you would follow as an auditor in a fraud
investigation.
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(6 marks)
(Total: 20 marks)
QUESTION FOUR
(a)
With reference to International Standard on Auditing 550
(Related Parties), discuss the responsibility of an auditor with regard
to related party transactions.
(b)
Required:
i)
Explain the factors you
would consider in deciding on the extent to which you could rely
on the work of the auditor of a subsidiary company. Your answer
should include a consideration of the size of the subsidiary.
(6 marks)
ii)
Analyse the matters you
would consider in deciding whether you should qualify your audit
report on the parent companys accounts given that the audit report
on the accounts of a subsidiary company is qualified.
(6 marks)
(Total: 20 marks)
QUESTION FIVE
You have recently been appointed auditor of UPS Hotels Ltd., a company
which owns and runs a number of hotels. The company has an
established internal audit department whose staff operate form the head
office and visit the hotels.
Each hotel has a computer which records the bookings of rooms for
overnight accommodation and produces the billing account for each
guest.
Required:
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(a)
Answers
69
3.
4.
5.
6.
Answers
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7.
Required:
(a) Describe the test data you would enter into the computerized sales
system to check the correct processing of dispatch notes and sales
invoices.
(8 marks)
(b) Explain how a computer audit program may assist you in
i) Carrying out a circularisation of accounts receivable including
selecting the accounts to circularize.
(5 marks)
ii) Verifying the year end receivables in the sales ledger.
(7 marks)
Notes:
i)
In part (a) you are not
required to describe how you would check the correct
processing of cash discounts, credit notes and adjustments to
correct errors.
ii)
You are not required to
describe in detail how you would carry out a circularisation of
accounts receivable. You are only required to consider the
aspects of a circularisation required by part (b) of the
questions.
(Total: 20 marks)
QUESTION TWO
There is a growing demand in both the public and private sectors for
professional accountants to provide assurance on a variety of subject
matters by expressing a conclusion regarding the quality or context of the
subject matter.
Required:
(a)
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(c)
interest
3,536,000
3,352,000
listed
9,912,000
9,880,000
13,448,000 13,232,000
Expenditure:
Payments for fees
Administration costs
Audit and accountancy
Sundry expenses
Net deficit for the year
11,304,000 11,544,000
1,728,000 1,640,000
376,000
360,000
224,000
208,000
13,632,000 13,752,000
(184,000) (520,000)
Answers
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2005
Sh.
2004
Sh.
Cost of investment
Fixed
interest 40,896,000 40,896,000
investments
Shares
in
listed 115,648,000 101,016,000
companies
156,544,000 141,912,000
The following additional information has been provided:
1. During the year, some shares were sold at a profit of Sh.14,632,000
and the proceeds were re-invested in shares of other listed
companies.
2. There were not purchases or sales of fixed interest investments in
the year ended 30 June 2005. In the year ended 30 June 2004 some
of the fixed interest investments were sold and others purchases
using the proceeds from the sale.
3. The charity is managed by voluntary trustees who meet four times
a year, and the administrator keeps the minutes of the meetings.
4. The trustees receive application for school fees, and approve them
if they are suitable and there is sufficient income from the
investments.
5. The auditors of the charity prepare the financial statements from
the accounting records kept by the administrator and audit those
financial statements. Their audit report is addressed to the trustees
of the charity.
Required:
Describe the audit work the auditors should carry out in order to:
(a) Verify that school fees are paid to authorised schools. You should
consider how the auditors would verify the existence of the students.
(6 marks)
(b)
Verify income from investments. The audit tests should
verify that all the income from the investments has been received by
the charity and included in the financial statements, including
dividends from the shares in listed companies bought and sold during
the year ended 30 June 2005.
(10 marks)
(c)
Verify the ownership of the fixed interest investments and
the shares in listed companies.
(4 marks)
(Total: 20 marks)
QUESITON FOUR
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You are the manager responsible for the audit of BCD Stores Ltd. which
has a number of stores which sell household products to the general
public, including furniture, electrical equipment, cooking equipment and
carpets. The company has annual sales of about Sh.1,600 million. In
previous years audits, there have been problems with:
1. Misappropriations of inventory by employees and customers.
2. Slow moving and damaged goods which are worth less than cost, and
3. Incomplete recording of sales when the customers pay by cash (these
represent 55% of all sales)
The company has a small internal audit department, the staff of which
visit branches and perform appropriate audit work at the head office.
Required:
(a) Describe the work you will carry out and the matters you will consider
in planning the audit prior to the commencement of the detailed audit
work, including consideration of the timetable for the audit.
(12 marks)
(b)
Arriving
opinion on the financial statements.
marks)
at
an
(4
(Total: 20 marks)
Answers
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JUNE 2000
QUESTION ONE
Tutorial Note:
This question was set when the International Accounting Standards
(now called the International Financial Reporting Standards (IFRSs)
were being introduced or adopted in Kenya.
The changes that were necessitated by the introduction of IFRSs in
Kenya can be compared to the preparations that took place in the
European Union (EU) toward the adoption of IFRSs in January 2005.
The early adopters of IFRSs faced significant problems such that the
International Accounting Standard Board (IASB) released a new standard
IFRS 1 First time adoption of International Financial Reporting
Standards.
IFRS 1 replaced SIC-8. First Time Adoption of IAS as the primary basis
of accounting.
IFRS 1 applies when an entity adopts IFRSs for the first time by an
explicit and unreserved statement of compliance with IFRSs. In general,
IFRS 1 requires an entity to comply with each IFRS effective at the
reporting date for its first IFRS financial statements. In particular, the
IFRS requires an entity to do the following in an opening balance sheet
that it prepares as a starting point for its accounting under IFRS.
i)
ii)
iii)
iv)
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iv)
ICPAK has the role of interpreting Global Standards for the local
environment and to reconcile IFRSs requirements with local
requirements e.g. the Companies Act reporting requirements.
Answers
76
vi)
vii)
77
Answers
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SAMPLING
Due to the fact that we cannot test everything it is inevitable that we
sample items for audit
tests.
We apply statistical sampling techniques basically on the tests of
controls, transactions testing and where large populations of transactions
and balances are involved and out tests of control have indicated that they
are subjected to the same uniform procedures. Random numbers or items
selected by the computer are used. Similarly the optimum sample sizes
are based on Statistical Sampling Theory.
On verification of the balance sheet items the approach is biased towards
high value and high risk areas. Thus the statistical sampling adopted
includes consideration of stratified sampling.
We only draw conclusions on samples scientifically selected so that we
can support our decisions scientifically.
Those transactions or balances that are unusual, one-off or with related
parties, judgmental sampling is used and tests can be up to 100% to give
maximum assurance.
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ANALYTICAL REVIEW
We build up a history of the company based on a five year moving ratio
and trend analysis that is updated annually and necessary changes made
to the figures where those are changes in accounting policies.
We also make use of the trend analysis, investigations and budget
comparisons and explanations produced as a normal consequence in the
organizations normal activities and reporting of management accounts.
Based on this study we are able to apply analytical procedures and
predict the finical statement balances. These are then compared with the
actual achieved balances. When the evidence suggests that the figure is
not materially misstated a much reduced amount of substantive
procedures of details is performed. However, if the indication is that the
figures are materially misstated then the substantive procedures are
increased to cover for the detection risk.
We apply the procedures at the planning stage to identify audit risk areas
and new developments.
During the audit we use analytical procedures to confirm completeness,
accuracy and validity of information.
And at the final review stage to confirm consistency and completeness
and to support the conclusions arrived at using other procedures, and to
assess the overall reasonableness of the financial statements.
ANSWER THREE
1)
(i) The normal accounting policy adopted by the company. Whether the
treatment being adopted is consistent with previous years
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Answers
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ANSWER FOUR
Controls in a Computerised Information System can be classified as
follows:
1. General Controls
- Organisation and management controls
- Application systems and maintenance controls
- Computer operations controls
- Systems software controls
- Data entry and program controls
2. Application controls
The purpose of application controls is to establish specific control
procedures over the accounting applications in order to provide
reasonable assurance that all transactions are authorized and recorded
and are processed completely, accurately and on a timely basis.
Application controls can be classified into:(i) Controls over input
(ii) Controls over processing and computer data files
(iii) Controls over output
The questions deals specifically with input and processing controls
and therefore the student should concentrate on these. (The question
instructs the student in note form, therefore lengthy descriptions will
not earn marks.)
Input controls will include input origination controls and input
authorization controls.
a) Input origination control
- Edit checks
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- Validations
- Access controls
b) Input authorization controls
- Online access controls
- Unique passwords
- Terminal identification limiting access to specific terminals
- Online source documents
c) Batch controls and balancing
i) Types of batch controls include:
- Total monetary accounts
- Total items
- Total documents
- Hash totals
ii) Types of batch balancing
- batch registers.
- Control accounts
- Computer agreements
d) Input error reporting and handling input controls include
- Transaction log
- Reconciliation of data
- Documentation of user, data entry and control procedures
- Error correction procedures
Logging errors
Timely corrections
Approval of corrections
Suspense file
Error file
Validity of correction
- Anticipation
- Transmitted log
- Cancellation of source documents
In online or database systems control over input is also critical.
Batches can be programmed to be controlled by time of day, specific
terminals or individual input of data.
Processing errors include editing and validation controls. Validation
controls include:
- sequence check
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Limit check
Range check
Validity check
Reasonableness check
Table lookings
Existence check
Key verification
Check digit
Completeness check
Duplicate check
Logical relationship check
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Answers
1. Receive instructions from the clients and confirm the specific terms of
reference
2. Communicate with other auditors as a matter of professional courtesy
if the investigating accountant is not the auditor of the entity.
3. Discuss with the client and make logistical arrangements for the
investigation
4. Obtain background information on the investigation including
understanding the entity including its internal control and assess the
risk of material misstatement in the financial statements.
5. Gathering of preliminary information with regard to the business and
the valuation of shares
6. Prepare the report outline and discuss with the client so that the terms
of reference and client expectations are confirmed
7. Carry out the investigation and review in detail according to the
clients instructions and other professional or statutory requirements
8. Prepare my draft report and discuss it with the client
9. Finalise the report and deliver it to the client
10.Be available for further discussions, inquiries or other investigations.
Taking the above procedures ensures that the clients and the investigating
accountant understand their specific roles and expectations and thus
minimizes disagreements, and protects the auditor from litigation.
With regard to the financial statements and the valuation of shares,
matters to pay particular attention to include:
- After observing the above procedures, normal courtesies, obtain
copies of the audited accounts of the previous years (say three years)
and critically analyse them
- Whether the accounting policies adopted are suitable and have been
consistently applied over the years
- Perform analytical review of the figures and whether the figures and
rations make sense
- Whether there were any qualifications in the auditors reports for the
previous years and the nature of the qualifications
The audited accounts for the current period will be reviewed including:- Tests of controls over the controls relevant for the preparation of
reliable financial statements
- Search specifically for any evidence of creative accounting such as
fictitious sales, over valuation of assets, understatement of liabilities,
big bath provisioning, impairment of assets and vice versa.
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After the above, I would then pay particular attention to the basis of the
valuation of shares.
In general, the value of equity shares are determined by the expected
performance of the business and current financial performance, position,
cashflows and the perceived economic environment.
In particular, attention will be focused on:The relevance and reliability of forecast performance and economic
benefits inflow. The benefits expected to be derived from continuing to
hold the shares such as expected dividends, capital gains and control of
the resources of the company. Historical figures are important as a basis
for forecasts.
Evaluate the methods of share valuation and ensure the accuracy of the
computations.
There are two main bases;
1. Earnings basis
2. Assets basis
The earnings basis has two approaches;
1. Dividend yield method
2. Earnings yield method
The assets basis has two approaches also
1. Going concern basis
2. Break up value basis
Since the company is a going concern and the shareholding to be
disposed off is significant, the methods of dividend yield and break up
value is not relevant.
In my procedures, I will ensure that they have not been used.
I would review the computations obtained using any of the other two
methods and ensure that the value is reasonable, taking into consideration
the nature of the business.
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JULY 2000
QUESTION ONE
1.
2.
3.
4.
5.
6.
7.
8.
9.
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schemes are run independently of the company and that the funds
are not available to the managers of the company. Any
organization that contradicts the provisions of the retirement
benefit authority are punished heavily.
Directors pay should ideally be determined by the shareholders at
the annual general meeting. It appears that the majority of the
shareholders in Kenya do not know this and they keep on
delegating this task to the directors themselves.
The accounting profession should educate the shareholders in their
role in fixing the directors remuneration. In addition, organizations
should set up audit committees, which among other things will vet
the directors pay.
Insider trading refers to the use of insider information either for the
benefit of oneself or a third party. To deal with this problem, the
auditing profession should have stern penalties for its members
who are found to be guilty of this vice. Organizations should also
restrict ownership of shares by people who have access to insider
information. Such parties as directors, employees and auditors
should not own shares in their respective organizations.
The feeling that auditors are too close to the clients is brought
about by the fact that audit clients rarely change auditors thus, as a
result of auditing the same client for many years, it is felt that
relationships inevitably develop, which will influence the
effectiveness of the audit.
The accounting profession can be able to alleviate this problem by
ensuring that clients change their auditors periodically. It should
set a ceiling for a number of years that, an audit firm can audit a
client continuously at say five years.
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will agree with them even if it means that the auditor has to
compromise his objectivity.
Opinion shopping should not be confused with obtaining a second
opinion on an auditors report by a different auditor other than the
one who carried out the audit.
In order to address this situation, the accounting profession has
given the auditor the right to make a representation at the general
meeting at which it is proposed to replace him. As only the
shareholders can remove an auditor from office, it is expected that
the auditor will be able to inform them on the reason that the
directors want him removed (which is that they do not agree with
his report on the financial statement).
However, in Kenya, even though this right exists it usually does
not seem to serve its purpose because:
Shareholders do not exercise their right to remove and appoint an auditor.
They usually delegate this duty to the directors. Thus, effectively, the
directors can be able to appoint and remove an auditor who does not
agree with them very easily.
Therefore in order to address this situation:
1. Organizations should educate their shareholders on their
rights especially in relation to auditors appointment and
removal.
2. The auditor who is incoming should communicate with the outgoing
auditor to establish pertinent issues which relate to his appointment.
If he establishes that, the company is out on an opinion-shopping
mission, he should decline the appointment.
QUESTION TWO
(a)
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access. This is possible because the computer can keep a log of all
operations carried out on a particular transaction.
Errors embedded arise from a basic weakness in the system, and
therefore they may recur frequently. In a stock control system,
such an error may be the failure to restrict access to authorized
personnel (by means to passwords) thus enabling the data to be
tampered with.
(b)
Segregation of Functions
In a centralized system, the principal segregation is between the
user department and the computer department. The key principle
behind it being that those who process the data should have no
responsibilities for imitating or altering the data. The following
segregation of responsibilities are particularly important.
RESPONSIBILITIES
exercises
running of the
department
2. Systems analyst
designing
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develops, debugs
programmers
4. Computer operator
into the
5. Librarian
systems
maintains custody of
documentation
(c)
(d)
and
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Acquisition of companies;
Purchase of business;
Prospective investments;
Admission of new partners
Prospective lending;
Fraud;
Systems breakdown;
Company acts investigation;
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and you will find that companies, individuals, financial institutions and
banks, local authorities, the tax authorities can all commission various
investigations.
Investigations: the stages
All investigations are carried out in the same way.
Stage 1:
You must always obtain precise written instructions from the client. This
must incorporate a very clear view of the aims of the investigation, the
scope of the investigation, the degree of the detail required, the degree of
secrecy to be observed, and the person to whom the accountant must
address his report. At this level, consideration must be given to the
resources the client is ready to utilize and the cost of the job, both in
terms of money and time.
Stage 2. Professional courtesies
Professional etiquette requires that if investigations are carried out in the
affairs of organizations to whom the accountant is not the auditor then the
auditors must be communicated with. This is to observe the usual
courtesies and to obtain their cooperation.
Stage 3: organization of the investigation
This involves the accountant assessing the aims of the investigation,
estimating the time to be taken and the likely costs and ensuring that the
appropriate staff will be available.
Stage 4: obtaining the background information
This is particularly important in investigations in acquisition of business.
It involves gathering as much background information as possible about
the object of the investigation, the size of the industry and its structure,
history since commencement, the future prospects, the relevant
legislation affecting that industry, investment information and relevant
accounting ratios. This information is usually available from published
sources such as government statistics, trade associations and the financial
statements.
Stage 5: gathering preliminary information
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Part C:
the report
Part D:
a statement of the scope of investigation stating the time,
period and the area covered
Part E:
a statement of the documents use. If it is necessary to
reproduce any of these documents this is usually done in an
appendix.
Part F:
an outline of the work actually done, again it may be
necessary to put some of this material in an appendix.
Part G:
Part H:
further information which could be of use to the client but
does not flow from the investigation proper.
Part 1:
Recommendations of the accountant. In giving
recommendations, the accountant must always ensure that:
a) He gives information from which the client can draw
his own conclusions
b) Avoid presenting information in such a way that the
clients judgment is influenced.
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Stage 9:
1. Ascertain the level of authority and the nature of duties of the cashier.
In this case, the cashier is responsible for the payment and receipt of
cash and the payment of wages and is also the bookkeeper. As such
there is a major weakness in the cash system due to the lack of
segregation of duties. The cashier carries out all the functions of the
cash system (receiving, paying and recording), hence there is no
internal check. All this increases the possibility of fraud.
2. Cast and vouch the cashbook and obtain certificates of opening and
closing balances from the bank.
3. Check the cash book against bank statements paying
particular attention to the dates of lodgment to ascertain
whether receipts were banked promptly
4. Examine pay in slips at the bank and compare with
counterfoils to reveal teeming and lading.
5. Scan the cashbook for any apparent irregular payments.
6. Examine returned cheques comparing names of payees with the
details in the cashbook and invoices
7. Obtain duplicates of missing expenditure vouchers
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QUESTION FIVE
(a)
1.Items at an auction are usually sold to the highest bidder and the
company should not participate in the auction. In the case of
Nyama Safi, the auctioneer firm belongs to the wife of one of the
directors and by virtue of that, is a related party to the organization.
Related party transactions are usually subject to terms and
conditions that are not applied to arms length transactions.
Therefore the appointment of the auction firm should be put under
scrutiny to determine if the appropriate procedures were followed.
Again evidence showing that the items were auctioneered need to
be examined to determine if the item was sold to the highest bidder
or not. If not, then the auction firm should pay to Nyama Safi the
difference.
b)
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In this case cars were sold to the directors at net book values,
which were between the realizable or market values.
The action I would take is to ask, the directors to pay more money
to Nyama Safi in order to bring the total amount of money paid to
the market value of the cars, failure to which I would encourage
the receiver to seize the cars and sell them and refund the directors
their money.
Over and above that, I would advice the shareholders to take legal
action against the directors for embezzling the assets of Nyama
Safi. The directors were supposed to act in the best interest of the
company and not to enrich themselves by taking undue advantage
of their position.
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DECEMBER 2000
ANSWER ONE
(a) Procedures to be undertaken to minimize the risk of a breakdown
of the system
1.
Have a maintenance agreement with the supplier to regularly
service the system
2.
Have an independent power supply source to cater for unexpected
power failure
3.
Safeguard the equipment from hazard such as floods and fire by
placing the main computer in a secure room and having other parts
of the system insulated
4.
If the system requires special atmospheric conditions such as air
conditioning or dust free room, make arrangements to ensure that
this is complied with
5.
Regular back up must be done, probably on a daily basis
6.
Arrange with a supplier for a replacement, should it be required so
that if certain equipment breaks down, the replacement is available
for a period of time.
(b)
i)
ii)
iii)
iv)
v)
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and
investigated
for
any
(d)
ANSWER TWO
(a)
The first matter for the auditor to quantify the total costs of this
type of expenditure. This would be done by examining the costing
records of job SPOO1 and checking the accuracy of the attributed
costs to underlying documentation. This will involve the cost of
the materials, used labor, time and appropriate rates and testing the
accuracy and reasonableness of the overhead allocation to the job.
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unlikely that the auditor will be able to discover the true nature of
these transactions. In these circumstances the auditor should express a
qualified opinion or a disclaimer in his report on the basis of the
limitation of scope of the audit. If the auditor is able to conclude that
there is a fraud and its effect is material and has not been properly
reflected in the financial statements this could lead to an 'adverse'
audit report.
Where fraud involves senior management including members of the
board, the auditor should consider reporting to an audit committee, if
one exists, or taking legal advice. As the last resort the auditors
should consider withdrawing from the audit, as there could be no
reliance on managements representations.
ANSWER THREE
The procedures that could have been adopted to detect the fraudulent
activities of Mr. A. Chiengo would have included the following:
(i)
(ii)
(iii)
(iv)
(v)
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(viii) Attending a stock take and comparing the records with actual
quantities counted.
(ix) Analytical review involving audit risk areas and figures that do not
make sense.
The companies Act, Section 162 gives the auditors unrestricted
access to the documents, vouchers and accounts of the company.
The confidentiality agreement constitutes a very serious breach
and places a material scope limitation on the auditors. The
auditors would be unable to conclude on the completeness,
accuracy and validity of a significant number of transactions and
balances.
They will not have received all the information and explanations
deemed necessary for
the purposes of their audit. This is a ground for qualifying their
report. If therefore the
auditors had not qualified their report they would have made a big
mistake. It is
unethical for auditors to accept an engagement under such terms
that restricts their
scope
(c)
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(d)
(i)
He does not exercise due care and skill during the performance of
his professional assignments or
He fails to detect material misstatements caused by errors or
irregularities including frauds which a reasonably competent
auditor would have detected or
He has performed his audit and failed to comply with approved
auditing standards or generally accepted auditing practices or
procedures.
(ii)
(iii)
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Net profit: This is the net trading profit (exclusive of all capital
receipts and outlay properly chargeable to capital) resulting from
the business of the insured at the premises after due provisions has
been made for all standing and other charges including
depreciation.
3.
4.
fire.
5.
Rate of gross profit: The rate of gross profit earned on the turnover
during the financial year before the financial year in which the fire
took place
6.
7.
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represent, the results which, but for the fire, would have been obtained
during the relative period after damage.
Turnover attained in 12 months just before the fire is called annual
turnover.
Procedure for computation of claim:
1. Calculate the short sales by comparing sales made during abnormal
period in the year of fire with the sales of the same period in the
financial year immediately preceding the fire. It should be noted
that:
(a) Calculation of short sales is to be made for the period of
dislocation due to fire or period of indemnity according to
policy, whichever is less;
(b) The sales last year may be adjusted up/down to consider trends,
in business growth in arriving at short sales.
2. Calculate the rate of gross profit in the last financial (accounting)
year preceding that of the fire. Calculations of gross profits margin
for loss-of-profit policy is different from the normal rate of gross
profit (Margin). For loss of profits it is computed as follows:
= Net profit + Insured standing charges or Sales x 100
*
The net profit excludes income from investments etc.
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Gross profit here means the gross profit that would have been
earned on the 12 months ending on the date of the fire.
(c)
Compute the margins for the last five years, based on the audited
accounts to 31 December 1999.
(ii)
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Determine that all other components except closing stock and gross
profit for the trading period to 13 June 2000 are pout into the
trading account.
(b)
ACCOUNTANTS CERTIFICATE
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An audit committee has various responsibilities which include: Review of a companys internal control procedures
Review of the internal audit function.
The audit
committee providing an independent reporting channel
Review of the companys current accounting policies and
possible changes resulting from the introduction of new
accounting standards
Review of regular management information (e.g. monthly
management accounts).
Review of annual financial statements presented to the
shareholders
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JUNE 2001
QUESTION ONE
(a)
Further procedures to be adopted in order to reach a conclusion on
whether the companys system of control can be relied upon include:
1. Obtain copies of the invoices that cannot be traced from the supplier.
Compare this invoice obtained from the supplier and the uninitiated
one with the related purchase order which was initially sent to the
suppliers. Compare this with purchase order with the related goods
received note. Confirm the receipt of these goods as evidenced by the
goods received note to the stock cards of concerned stocks. If all the
above documents are in agreement, this would indicate the validity of
the liability or payment, if not, this would indicate a lapse in the
internal control system which would affect the extent to which it can
be relied upon.
2. Approval of invoices for payment that are not initialised (as evidence
of being checked) would indicate a departure from the prescribed
internal control. Thus, I would increase my sample size to determine
if it is common for invoices to be approved that are not checked.
3. Carry out a walk through test on the altered stock cards by tracing the
entries on these stock card to the documents of origin such as:
The purchase order
The goods received notes
The suppliers invoice
This would help me to determine whether the adjustments were
correcting errors or they were fraudently done. I would also make
enquiries regarding this adjustment from the responsible officers or
employees.
For the supplier who is paid on the basis of the pro forma invoice.
I would select a sample of these pro forma invoices and carry out a
walk through test by: Trace the pro forma invoices to their related purchase orders and
determine whether the goods were actually ordered.
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The principal limitation of the report included: (i) Only those matters that come to the auditors attention are reported
on.
(ii) If the shortcomings point to management weaknesses they are
unlikely t be corrected or implemented on a timely basis.
(iii) The shareholders or the regulatory authorities may not receive a
copy of this report and thus only one executive director may see it.
QUESTION TWO
1. Nakuru Motor Spares is a material debtor to Nairobi Motor Spares ltd.
However the client is of the view that they have obtained a floating
charge on the stock of Nakuru Motor Spares hence no need to make a
provision
To determine whether a provision is necessary, I will need to take the
following factors into consideration:
a) A floating charge is an equitable charge securing a loan on the assets
of a going concern. It remains dormant until crystallization.
Therefore, the issue is what are the chances that the charge will
crystallize? It seems to me that there are high chances of
crystallization as the customer, Nakuru Motor is a slow payer and his
debt has increased over the year. This should cast doubts on the
going concern of Nakuru Spares, as it seems to have difficulty in
meeting its current obligations.
b) A floating charge created six months before winding up is void since
Nakuru Spares seems to be in financial difficulty, it is worth
considering the date the charge was created.
c) A floating charge is subordinate to any specific charge, therefore I
would consider whether there exists other charges which are superior
to this charge.
d) The charge may crystallize at a moment when Nakuru Spares does not
have any items at hand or the stock may be worth less the amount
owed occasioning a loss to Nairobi Spares. Again, these stock may
need to be resold at a value which cannot be predetermined.
Therefore in conclusion a provision is still required due to the above
limitations.
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2. The occurrence of so many errors indicate that their stock value in the
records could be misstated. Many items could be carried at wrong
quantities and values. Therefore the auditor should attempt to
reconcile the physical count with computerized book stock records to
determine the extent of misstatement of the stock value. The auditor
may: -
a) If the physical count was reliable, the auditor may use these
quantities as the basis of valuing the items. These values would be
compared with the latest purchase invoices and if the resultant
valuation shows a reasonable comparison with the computer
generated values, no provision is necessary. If the differences are
material, the auditor should consider whether proper books of
accounts are kept or not. If not, this would constitute a limitation
on scope. The auditor should then consider whether the limitation
of scope is so material and persuasive that a disclaimer of opinion
or qualified opinion is call for.
b)
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The decision to sell the wholly let out property to third parties
should also be screened to see whether this is not an attempt to
massage earnings.
Accounting for leasehold properties in governed by IAS 17
Leases, and the depreciation provisions of IAS 16 also apply.
ii)
iii)
iv)
v)
vi)
vii)
Disclosures required.
QUESTION FOUR
The Finance Director
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iii)
iv)
In the case of the banking subsidiary, has the same reporting date as
the parent and control is direct, only the disclosure in (iv) above may
apply.
With respect to the Companies Act, cap 486, Laws of Kenya, Group
Accounts are required under section 150 which states that where at
the end of its financial year, a company has subsidiaries, accounts
statements dealing with the state of affairs and profit and loss of the
company and the subsidiaries shall, subject to subsection (2) be laid
before the company in general meeting when the companies own
balance sheet and profit and loss account are so laid.
The Companies Act allows exclusion from consolidation on the
following bases;
1) Group accounts shall not be required where the company is at
the end of its financial year the wholly owned subsidiary of
another body incorporated in Kenya and;
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iii)
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v.
To enable the auditor point out areas where management could be more
efficient or more effective or where economies could be made or
resources used more effectively.
The contents of the report include:
i.
ii.
iii.
iv.
v.
vi.
vii.
Items (iii) and (iv) may require the auditor to qualify his report to the
members as required by statute.
The proposal that the report to management by the auditors should be
distributed to the shareholders as well as the financial statements has
some merits such as:
i. Giving the shareholders more information on how their funds are being
controlled and thus giving them increased opportunities for monitoring
their investment and checking the performance of the directors. It will
alert the shareholders to breaches by the directors of legal and other
requirements, items that due to materiality considerations do not
appear in the auditors report to shareholders.
ii. Bad investment decisions by the directors and inefficient,
uneconomical and ineffective policies of the directors will be
highlighted.
On the other hand, the main role of the auditors is not to judge on the
ability of the management. Distributing the report to the shareholders
would therefore have the following demerits:
i.
ii.
iii.
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DECEMBER 2001
QUESTION ONE
a) According to ISA 200, objectives and general principles governing an
audit of financial statements audit risk is the risk that the auditor
expresses an inappropriate audit opinion when the financial statements
are materially misstated. The ISA requires the auditor to plan and
perform the audit to reduce audit risk to an acceptably low level that is
consistent with the objective of an audit.
The ISA states that the objective of an audit of financial statements is
to enable the auditor to express an opinion whether the financial
statements are prepared in all material respects in accordance with an
applicable financial framework.
(i) Audit risk is a function of the risk of material misstatement of the
financial statements (risk of material misstatement) (i.e. the risk
that the financial statements are materially misstated prior to
audit) and the risk that the auditor will not defect such
misstatement (detection risk)
Therefore audit risk has the following components:- Risk of material misstatement
Inherent risk
Control risk
(ii) Inherent risk is the susceptibility of an assertion to a misstatement
that could be material, either individually or when aggregated with
other misstatements, assuming that there are no related controls.
(iii) Control risk is the risk that a misstatement that could occur in an
assertion and that could be material either individually or when
aggregated with other misstatements, will not be prevented or
detected and corrected on a timely basis by the entitys internal
control. Control risk is a function of the effectiveness of the design
and operation of internal control in achieving the entitys
objectives relevant to the preparation of the entitys financial
statements.
(iv) Detection risk is the risk that the auditor will not detect a material
misstatement that exists in an assertion that could be material
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(iii) Check sequence of order forms used and whether missing items are
investigated
(iv) Observation of operations of the system such as when goods are
being delivered and the documentation process.
QUESTION TWO
Note: The dates given in this question are important in answering the
question.
The key issues in the question are accounting requirements, audit
reporting and subsequent events.
1. Improvements to leasehold premises
a) Treatment in the financial statements. The authoritative document
on accounting for leases is IAS 17 leases. This standard in
addition to the provisions of IAS 16, property, plant and
equipment, allow for the capitalization of the major improvements
and subsequent amortisation over the life of the lease (25 years).
This applies to finance leases, not operating leases.
The premises were vacated on 20th October 2000 when the
auditors report had already been signed. The fact that no tenant
could be found could mean that the asset was impaired, but this
would not make the auditor negligent.
b) The auditors were not negligent. However, it will depend on
whether the plans to vacate the premises and the reasons for the
vacation. Was management and auditor aware of plans to vacate
the premises.
2.
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d. How the intangible asset will generate probable future
economic benefits
e. The availability of adequate technical, financial and other
resources to complete the development and to sue or sell the
intangible asset
f. Its ability to measure reliably the expenditure attributable to
the intangible asset during its development.
If an entity cannot distinguish research phase and development
phase of an internal project, the entity treats the expenditure on
that project as if it were incurred in the research phase only.
The deferred expenditure in the question is shown as
consolidation of pure and applied research and development
costs. If it was not possible to separate research and
development phases, then the whole amount should have been
expensed in accordance with IAS 38.
If it were possible, then the amounts should have been
separated, with the research phase costs being expensed when
incurred and the development being recognized as an intangible
asset and amortised accordingly.
The production of the product ceased in July 2000, before the
audit report was signed. This is an adjusting event meaning that
the intangible asset was impaired as at the balance sheet date
(refer to IAS 10, Events after the balance sheet date, and ISA
560 subsequent events)
b) Auditors negligence
If this information was available during the audit and when the accounts
were being signed, then the auditor may be negligent. He should have
discussed the issue with client management for the financial statement
to be adjusted or disagreement, modify his opinion.
3.
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a)
Accounting treatment
Financial guarantees are within the scope of IFRS 4, Insurance
contracts. In the case of Jos Ltd, the guarantee is to a company
controlled by the directors hence this is a related party transaction
which should have been disclosed as per IAS 24, Related parties.
As per IFRS 4, the guarantee does not fulfil the definition of an
insurance contract because it is not made to a separate entity.
In the separate financial statements of Jos Ltd, disclosure should be
made in accordance with IAS 37.
b) Auditor Negligence
The auditor may be negligent depending on whether the
information about the guarantee was available and there was no
limitation of scope. He should have advised management on the
implications of not disclosing to his audit report.
5.
Redundancy payments
a) Accounting treatment
The management decision alone is not a past obligation event.
According to IAS 37, no provision was to be recognized on the
balance sheet date. IAS 37 defines a contingent liability a possible
obligation that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or
more uncertain future events not wholly within the control of the
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entity or a present obligation that arises from past events but is not
recognized because it is not probable that an outflow of resources
embodies economic benefits will be required to settle the
obligation or the amount of the obligation cannot be measured with
sufficient reliability.
In the above question, as at the balance sheet date, there was no
obligation. However, the implementation took place before the
audit report was signed hence disclosure was required under IAS
10. Events after the balance sheet date, which was done.
b) Auditor negligence
The disclosure was in accordance with the applicable financial
reporting framework hence the auditor is not negligent.
6.
QUESTION THREE
The Managing Director
LF Ltd
P O Box 2411
KHN 00202
135
NAIROBI
7 December 2001
Dear Sir/Madam
Advise on Accounting for the Deficiency in the Pension Fund
I refer to your request for advice on various issues regarding the
deficiency in the self administered defined benefit pension fund.
You have requested that I advise on:
(i) How each of the alternative methods of rectifying the position would
match the true and fair view requirement
(ii) Whether the payments should be treated as normal, exceptional,
extraordinary deferred or prior year items
(iii) Other matters to be born in mind when considering the three
alternatives
I will briefly explain the accounting framework for the defined benefit
pension schemes, how the deficiency arose then I will discuss of the three
alternatives in them.
Defined benefit schemes are accounted for in accordance with
International Accounting Standard No.19, Employee Benefits.
For defined benefit schemes, the actual cost of the scheme has to be
estimated and depends on:
a) Employee salary at the date of retirement
b) The proportion of employees that remain with the employer until
retirement age
c) The average life span of pensioners
d) The effect of inflation on cost of living adjustments to pensions
when paid
e) The performance of the investments
The main issue in defined benefit schemes is that the obligation to pay
benefits is recognized as the employees render their services. The actual
cost in a given financial period is not likely to match the actual
contributions.
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The true and fair view requirement demands that costs be recognized as
employees render their services and the estimated cost not the actual
contribution account for in the income statement.
OPTION 1
To make an immediate payment to clear the difference.
The suitability of this depends on the availability of funds. It may not
present true and fair view if the deficit which relates to prior periods is
expensed in the current period alone. It may show reduced profitability
or fluctuation in performance.
If this option is exercised, it will be necessary to recognize prior period
adjustment for the past costs charge in the income statement for the
current year costs and a deferred cost for the portion of future costs till
the next actuarial review.
OPTION 2
Clear the deficiency by equal payments over the following five years.
This spreads out the burden on cashflows and may give a better regard to
the true and fair view principle. If this option is exercised, a liability
should be recognized and payments offset against it but additional
disclosure in the notes to the accounts will need to be made explaining
the whole position. A charge in the profit and loss account for the current
year costs and deferred costs for the portion of future costs.
OPTION 3
To increase the employers future contributions by a specified percentage.
Under this option, the increased amount will have to be split between a
prior portion and current portion with a liability recognized for future
obligations.
Other factors to be considered include;
- Liquidity position of the company
- The changes in the variables which determine the defined benefit
obligation
- The changes or revisions of pronouncements of the applicable
financial reporting framework
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Procedures to be performed include:1. Obtain financial statements for the preceding financial periods
2. Evaluate the accounting policies and methods of valuing and
accounting for inventories
3. Consider the consistency and thoroughness of controls on inventory
and financial reporting
4. Discuss adjustments done when physical courts are done
5. Calculate operating ratios; gross profit, net profit, insured standing
charges, indemnity period, rate of gross profit, annual turnover,
standard turnover.
6. Establish the trend of the businesses and variations in or special
circumstances
7. Establish the accuracy of the procedures used in establishing the
claims
8. Obtain the insurance policies, establish the rights and conditions under
the policy and note any exclusions that may affect the client
9. Perform the following steps in obtaining the consequential loss
claimed:(i) Calculate the short sales by comparing sales made during the
abnormal period in the period affected by the fire with sales of
the same period in the financial year immediately preceding the
fire or period of indemnity.
(ii)
(iii)
(iv)
(v)
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(iv)
Check for the reasonableness of the balancing figure, which represents
the closing stocks cost.
b) ACCOUNTANTS CERTIFICATE
REVIEW REPORT TO OMEGA FURNITURE LTD ON CLAIM
FOR LOSS OF PROFITS AND LOSS OF STOCKS
We have reviewed the enclosed claim for loss of profits and stocks
resulting from the fire Omega Ltd suffered on 13th June 2002, which
led to the closure of the companys business till November 2002 when
it re-opened after rebuilding of the factory.
This claim is the responsibility of the companys management. Our
responsibility is to issue a report on these components of the financial
statements based on our review.
We conducted our review in accordance with the International
Standards on review engagements (ISRE) 2400. This standard
required that we plan and perform the review to obtain moderate
assurance as to whether the components of the financial statements are
free of material misstatement. A review is limited primarily to
inquiries of company personnel analytical procedures applied to
financial data and thus provides less assurance than an audit. We have
not performed an audit and accordingly, we do not express an opinion.
Based on our review, nothing has come to our attention that causes us
to believe that the accompanying claim does not give a true and fair
view in accordance with International Financial Reporting Standards
(IFRSs)
QUESTION FOUR
(a) Based on the information given it appears that P.Shah should consider
the purchase a modular integrated accounting packaged and create a
small local are network (LAN) of two or three terminals. This will
allow the company's systems to be computerized in stages and also
facilitate several employees accessing different modules at the same
time. Other considerations would be:
(i) It is necessary to consider the cost and benefits of such a decision.
Computers and related software are relatively cheap, and even small
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Answers
debtors, creditors and other balance sheet figures are printed out and a
copy of the transaction data files are produced at this time. If necessary,
the auditor can restore the year-end data to perform, audit tests. In
practice it is safer to do this on the auditors own system (assuming he has
a duplicate system programme) to avoid any potential corruption of client
data.
A consequence of the change is that the auditor will need to revise much
of the audit documentation, particularly the audit programme, the
assessment of the system of internal control, and file copies of sample
documents generated by the new system.
(c)
The impact of information technology is rapidly affecting the auditing
profession. The speed and size of computer processing power allows
greater volumes of data to be held and manipulated leading to greater
reporting of financial information, much of which is likely to require
consideration by the auditor. Modern auditors must possess the technical
skills to both control and take advantage of these developments. The
following are some of the changes that information technology is having
on the auditing profession:
(i) Many audit firms now have automated working papers. These are
generally held on PCs and can perform, amongst other things, the
following tasks.
1. Internal control questionnaires can be filled in on a PC. The system
can highlight any incomplete sections and thus any areas of weakness.
2. Analytical tasks such as ratio calculation, selection of sample sizes
and the generation of random numbers.
3. CAATs are becoming more sophisticated with a consequent
improvement in the quantity and quality of generated audit evidence
leading to greater audit efficiency.
4. The development of expert or decision support systems allow
junior audit staff to make judgmental decisions using knowledge
gained by experienced staff. These are still in the development stage
but can give guidance on materiality issues, automation of checklists,
tax calculations etc.
5. Modern computers are changing the working pattern of many staff
improvements in portable note book computers and the possibility of
world wide data transmission via telephone wires, fibre optic cable
and even satellites mean that auditors can be in touch with, and have
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QUESTION FIVE
1.
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Answers
(iii)
(iv)
(v)
(vi)
(vii)
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Answers
The audit firm should correspond with the non-clients own audit
firm in order to obtain all the information at hand. If it appears
that the non-client is opinion shopping then the audit firm should
consider its ethical position and possibly refuse to give an
opinion.
(iv) Existing legalization gives auditors the right to present their case
to the members against removal either verbally at a general
meeting or in writing prior to their removal. Similarly where an
auditor resigns from his office, he may make a statement
regarding the circumstances of his resignation which must be sent
to the registrar and every person entitled to receive a copy of the
financial statements. However, auditors seldom publicize their
point of view when being dismissed for fear of being branded
controversial. However, if audit firms were prepared to
publicize their viewpoint more forcibly the adverse publicity
might dissuade company directors from finding a more cooperative audit firm. Also the prospective auditors would
possibly be dissuaded from accepting the appointment, if greater
publicity was given the circumstances behind the previous
auditors dismissal.
4.
Audit firms can reduce the risk of litigation and its effects upon the
audit practice by adopting the following procedures:
1. Ensuring that all audit engagements follow Auditing Standards.
2. Establishing quality control procedures and practice standards of
the highest quality.
3. Adopting rigorous client acceptance procedures.
4. Ensuring adequate professional indemnity insurance.
5. Developing a positive litigation strategy. Audit firms often have
actions brought against them, which would fail in a court of law.
Historically some firms have made nominal out of court
settlements in order to avoid publicity but others have refused to
deal with this type of lawsuit in this manner choosing to go to
court and allegedly this has discouraged potential plaintiffs.
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JUNE 2002
QUESTION ONE
THE STOCK SYSTEM
The stock system can very important in an audit because of the high
value of stock or the complexity of its audit. It is closely connected with
the sales and purchases system.
Control considerations
2.2 Stocks may be as susceptible to irregularities as cash and, indeed, in
some circumstances the risks of loss may be materially higher.
Arrangements for the control of stocks should be framed with this in
mind.
2.3 The stock control procedures should ensure that stocks held are
adequately protected
against loss or misuse, and are properly
applied in the operations of the business.
2.4 Stock should be duly accounted for by appropriate recording and
authorization of all movements.
2.5 It is also important that the business has proper control over stock
levels to prevent on the one hand the possibility of running out of
stock and on the other of holding too much stock, and hence incurring
increased holding costs and the risk of stock obsolescence.
A further aim should be to ensure stock is appropriately valued, and that
write-downs of stock are kept to a minimum.
According to the nature of the business separate arrangements may be
necessary for different categories of stocks, such as raw materials,
components, work in progress, finished goods and consumable stores.
Other controls:
1.
2.
3.
4.
5.
6.
7.
Segregation of duties;
Custody and recording of stocks received
Checking and recording of goods inwards
Precautions against theft
Misuse and deterioration
Restriction of access to stores
Controls on stores environment (temperature, precautions against
damp)
8. Control of stock levels
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Receipts by post
Safeguard to prevent interception of mail between receipt and opening
Appointment of responsible person to supervise mail
Protection of cash and cheques (restrictive crossing)
Amounts received listed when post opened
Post stamped with date of receipt
Maintenance of records
Limitation of duties or receiving cashiers
Holiday arrangements
Giving and recording of receipts
Retained copies
Serially numbered receipt books
Custody of receipt books
Comparisons with cash records and bank paying in slips
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150
QUESTION TWO
According to the framework for preparation and presentation of financial
statements, going concern is a fundamental assumption whereby it is
assumed that; (i) The entity will continue in operation in the foreseeable future
(ii) The entity has is neither the intention nor the need to liquidate or
curtail materially its scale of operations
Thus, the going concern assumption assumes that the company will be
able to discharge its operations normally and meet its financial
obligations as they fall due.
In the case of a given company, the factors that could indicate that the
going concern assumption may be put into question can be described as
follows; 1.
2.
3.
4.
5.
6.
7.
8.
9.
(B)
(a)
(b)
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highly geared means that the interest expense can reduce the
margin such that little is left to finance other costs. Use of
expensive finance also indicates inability to obtain normal credit
and overdraft facilities.
Over trading
A company growing too fast may find itself unable to finance the
necessary investment in finance and stock holding.
Dependence on one supplier, customer product or market.
This means that insolvency or loss of such suppliers or collapse of
market for the product could precipitate crises that could lead to
the death of the company.
Long term loan reaching maturity without realistic chances of
obtaining alternative financing.
Such loans are usually secured on significant and indispensable
assets of the company thus if new facilities cannot be negotiated
quickly, the entity may lose its productive facility as they are sold
to settle the liability.
Receiving losses
Eventually a loss making company will run out of money thus
have going concern problems.
Dividend arrears
Shareholders not getting a return on the investment will eventually
withhold their support for the company and may not subscribe for
more equity.
ISA 570: - Going concern. The auditors should assess the
adequacy of the means by which the directors have satisfied
themselves that:
It is appropriate for them to adopt the going concern basis in
preparing the financial statements and
The financial statements include such disclosures, if any, relating
to going concern as are necessary for them to give a true and fair
view.
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1. Disclosed in the financial statements in order that they give a true and
fair view and/or
2. Referred to in the auditors report (by explanatory paragraph or a
qualified opinion).
QUESTION THREE
(a) Profit and loss account
1. Carry out ratio analysis. I would compare the following ratios and
compare the rations with previous years ratios and the industry
average: Gross profit margins
Other operating ratios such as mark up.
3. Review the accounting policies used in preparing the profit and loss
account and assess whether:
a. They are consistent with the International Accounting Standards and
the generally acceptable accounting policies (GAAPS)
b. They are applied consistently from year to year.
4. Inspect the items within the profit and loss account to determine their
identity for example:
Sales - search for fictitious sales. Review of the sales daybook and
cashbook and cash sales will identify fictitious sales.
Expenses or purchases -review suppliers statement and trend of
payments made.
5. Visit a number of the business premises to assess the volume of
business actually being
achieved.
(ii) Balance sheet
1. Carry out ratio analysis. I would compute the following ratios.
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QUESTION FOUR
Point of sale terminal is a generic term for various types of devices used
in retailing business to capture sales and inventory data.
An electronic point of sale comprises of a range of electronic devices e.g.
Personal computers, barcode scanners etc that is used to capture sales and
inventory data at point of sale terminal. Point of Sale is wide spread in
supermarkets (like this company), which need regular information on
stock positions and stocktaking. Point Of Sale provides information that
includes.
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QUESTION FIVE
(a) An auditor may be liable for damages for material misstatements in
published accounts on which he has expressed an audit opinion in the
following circumstances: 1. His failure to detect error and fraud;
2. Carelessness or dishonesty on his part or by his audit assistants.
However, he may avoid liability by;
Planning and carrying out audit procedures that will provide him with a
reasonable expectation of detecting all material misstatements.
Again, it may be a defense to show;
1. There was no negligence
2. That no duty of care was owed to the plaintiff in the circumstances
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3. In the case of actions in tort, that no financial loss has been suffered by
the plaintiff.
(b) A successful, legal claim be brought against the auditor by: 1. His client, whom he owes a primary duty of cane
2. To third parties under the law of tort to assess the value of damages,
the tort will consider the following:1.
2.
3.
4.
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161
DECEMBER 2002
QUESTION ONE
To carry out starters and leavers test, I will select two payrolls, the first at
the start of the company's financial year and the second a recent payroll.
I will note:
1. Employees not on the first payroll who are on the second payroll.
These are starters.
2. Employees on the first payroll who are not on the second. These are
leavers.
For both starters and leavers, I will go to the personnel department and
find the date each employee started or left.
For starters I will check to the relevant payrolls that they were not paid
before they started employment. For most employees, the first payment
should be at the end of the week or month they started work and not for
the previous week or month. For manufacturing employees, the first
payment should be made the week after they started work and they
should not be paid at the end of the week they started work.
For leavers I will check to the relevant payrolls that they were not paid
after they ceased employment. For most employees, they should be paid
at the end of the week or month they finished work but not for the
subsequent week or month. For manufacturing employees, the last
payment should be the week after they left employment and they should
not be paid in the following weeks payroll.
An alternative way of performing this test is to start from the personnel
records of staff who have started or left during the period. I will check
that starters have not been paid before the period. I will check that
starters have not been paid before they started employment and leavers
have not been paid after they left employment in the same way as that
described in the two paragraphs above.
If I find any problems, I will discuss them with the company's
management. If I detect a fraud, this will require further investigation
and I should report it to the company's management and include it in my
management letter. This will suggest there should be greater controls
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over preventing frauds over starters and leavers, such as the personnel
department periodically checking the wages department are treating these
types of employee correctly.
(b) I will carry out the following audit procedures when I attend the pay
out of wages to employees:
1. Before the wages are paid, I will take a copy of the payroll and check
there is a pay packet for each employee. If the pay packet is
transparent, it may be possible to test check the money in the pay
packet agrees with the net pay on the payroll.
2. When the employee is given his/her wage, he/she should sign for it.
The signature should be test checked to the employee's signature kept
by the personnel department. I will mark on my list when each
employee collects his/her wage.
3. I will check that no employee receives more than one pay packet or
one for another employee. I will note if this is happening.
4. At the end of the wages payout, I will check that there is a wage
packet for each employee who has not collected his/her wage. These
will be the unmarked items on my payroll list. These are unclaimed
wages.
5. I will check that these unclaimed wages are recorded in the unclaimed
wages book. The information recorded in the unclaimed wages book
should include the payroll date (and payment date, if different), the
employees name and umber, and the net wage. I will note cases
where unclaimed wages are not recorded in the unclaimed wages
book.
This is not unusual, as frequently wages collected in the day of
payment are not recorded in the unclaimed wages book, and the
unclaimed wages book records only those wages, which are
unclaimed at the end of the day. This creates a weakness in the wages
payment system (although it is minimized by the employees signing
for their wages).
As indicated above, one of the purposes of attending the wages payout is
to check the existence of employees.
C) In checking the procedures over unclaimed wages:
1. I will have checked procedures for recording unclaimed wages in the
unclaimed wages book in part (b) (v) above. To qualitatively check
that the same procedures are carried out in the weeks when I did not
2.
3.
4.
5.
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165
5.
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166
6.
If not available, I will have to consider whether lack of the list consisting
a limitation in the scope of my work and if so, I would give a qualified
opinion i.e. a disclaimer.
QUESTION THREE
(a) The auditors responsibilities in the periods listed in the question are
given IAS 560 (subsequent events)
1. In the period 31 October to 6 December 2002, the auditor should carry
out sufficient appropriate audit work so that he/she has a reasonable
expectation of detecting and quantifying material subsequent events.
Examples of the types of audit procedures carried out are included in
part (b) of this answer.
2. In the period 6 December 2002 to 19 December 2002 the auditor's
responsibilities are the same as in the period (a)(i) above.
3. The period from 19 December 2002 to 5 January 2003, the standard
says that the auditor should reasonably expect the directors to inform
him/her of any material subsequent events detected in this period,
which may affect the financial statements. During this period auditors
do not have any obligation to perform procedures or make enquiries
regarding financial statements.
When the auditor becomes aware of material subsequent events in this
period, he/she should carry out appropriate audit procedures to
determine whether the subsequent event has a material effect on the
financial statements.
If the directors amend the financial statements, the auditor should
produce a new report on the amended financial statements.
If the directors do not amend the financial statements, and the
subsequent event is material, the auditor should consider how the
shareholders can be informed of the subsequent event. This may
include the auditors making a statement at the annual general meeting
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168
2.
3.
4.
5.
6.
7.
8.
9.
Answers
balances which are unpaid at the time of the audit will be potential bad
debts and further investigations should be carried out.
A debtor's circularization carried out after the year-end could be a post
balance sheet check of debtors at the year-end.
Checking sales after the year end to check recoverability of stock at
the year end, if for stock held at the year end, the selling price after the
year end is more than cost, then the stock can be valued at cost.
However, if the selling price is less than cost, this stock should be
valued at net realizable value.
Checking sales cut-off. Starting from the dispatch note, for sales
before the year-end, the sales invoice should be posted to the sales
ledger before the year-end. For sales after the year-end, the auditor
should check the sales invoice is not posted to the sales ledger before
the year end (technically, only this latter check is a check of
subsequent event).
Checking purchases cut-off. Starting from the goods received before
the year-end, the purchase invoice should either be posted to the
purchase ledger before the year-end or included in purchase accruals
at the year-end. For goods after the year-end, the purchase invoice
should be neither posted to the purchase ledger before the year-end
nor included in purchase accruals at the year-end.
Checking supplier's statements to the balances on the purchase ledger.
If the balances agree, this is good evidence that the purchase ledger
balance is correct. If there is a difference, it should be reconciled and
the auditor should consider whether the differences are reasonable.
Supplier's statements are an effective way of checking purchases cutoff, and of detecting late issue of cheques after the year-end.
Check any sales or disposals of fixed assets after the year-end. This
will check whether these assets have been sold for more or less than
their balance sheet value. If they are sold for less than their balance
sheet value, normally they should be written down to their realizable
value at the year-end.
Checking returns of goods from customers and other sales credit given
after the year-end. This helps determine whether the provision for
these items in the financial statements is reasonable. Similar checks
can be made for purchase items, such as goods returned before the
year-end when the credit is received after the year-end, and other
credits received from suppliers after the year-end.
Checking about legal claims against the company, which exist, at the
year-end. This will involve asking the company secretary and the
directors if there are any claims, and (with the clients permission)
asking the company's auditor, inspecting board minutes (see item (x)
below) could highlight any claims against the company. The bank
169
As no detailed audit work would have been carried out during the
period, there is a risk that material subsequent events may have
occurred in this period.
Thus, the auditor will have to ask the
director's and senior management, if any material subsequent events
have occurred in this period or whether further evidence is available
for uncertainties existing at 6 December 2002. Also the auditor
should examine such documents as Board and Management minutes,
management accounts and seek further evidence relating to
uncertainties at 6 December 2002 (e.g. whether a doubtful debit at 6
December has been settled).
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QUESTION FOUR
1. Stock valuation
The finance director's claim that the issue of the report after balance sheet
date is a non-adjusting event is irrelevant. As at balance sheet date the
material could not be used in road construction. In accordance with its
value, at the lower cost and net realizable value was 2 million. The issue
of the report failed to change the situation. The value of stocks and
operating profit should therefore be reduced by the amount of the write
down to net realizable value being 5 million. This amount is material
being in excess of 10% of operating profit.
If the company fails to adjust its financial statements, the effect on the
auditors report would be an expect for disagreement qualification as
the matter affects only stock valuation and is therefore not pervasive.
The opinion would be headed "Qualified opinion arising from
disagreement about accounting treatment". The first paragraph in this
section should describe the nature of the disagreement and quantify the
effect on the financial statements. The second paragraph would then
express the qualified opinion.
(b) Depreciation
Accounting for depreciation requires that useful lives of assets be
reviewed regularly and the depreciation adjusted where there is found to
be a change in useful life. The finance directors claim that technological
obsolescence need not be taken into consideration is not consistent with
depreciation for the current financial year should be adjusted so as to
write off the written down value of computer controlled earth movers
over their revised useful life.
Year
of
purch
ase
Remain
ing
useful
life in
years
includi
ng 1998
Required
depreciat
ion
charge
for 1998
on an
overall
basis of
Depreciat Adjustm
ion
ent
provided required
1998
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1995
1998
5,0
00
8,0
00
1,500
3,500
5 years
000
1,750
8,000
1,600
500
1,250
800
800
2,050
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be a time (and cost) saving if the audit firm both prepares and audits
the financial statements.
However, if the same staff both prepare the financial statements and
audit them, there is a greater risk that material errors will not be
detected, as one is poor at detecting one's own mistakes. Also, staff
may feel the item has been audited when preparing the financial
statements, and this could lead to aspects of the financial statements
being audited unsatisfactorily. So, it is desirable (and recommended)
that different staff should prepare the financial statements from those
who audit them.
Even in this situation, there is likely to be a cost saving, as the staff
preparing the financial statements should prepare schedules which
will help in the audit (e.g.) schedules of additions and disposals of
fixed assets, and calculation of accruals and prepayments). If the
audit firm prepares the financial statements, the letter of engagement
for this work should point out that the client should accept that the
accounting records are the responsibility of the company, and that the
financial statements are based on the company's records and
explanations received from employees and the directors.
In conclusion, the provision of accounting services is unlikely to have
any significant adverse effect on the auditor's independence.
(iii) The auditors may be quite good at advising on internal control
systems, as this is an important aspect of audit work. However, if the
auditor's recommendations are implemented and the system proves to
have weaknesses (which may result in serious errors or fraud), the
auditor may be reluctant to criticize the system (as he would be
criticized himself) so his independence would be compromised. For
this reason, auditors should not say how internal control systems
should be set up in client companies.
However, as a result of audit work, auditors can become aware of
weaknesses in internal controls in accounting systems. They should
point out these weaknesses to the client, and any errors or fraud,
which have taken place. In addition, they can suggest how the
systems can be modified to improve controls. The auditor can suggest
changes to parts of systems, but they should not say how a whole
system should be set up (e.g. a purchases system).
(a) Considering the points raised in the statement:
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Note:
As stated above, the argument for and against auditors providing nonaudit services are finely balanced. Candidates will not be penalized if
they come to different conclusions, based on a suitably argued case.
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JUNE 2003
ANSWER ONE
(a) Preliminary Considerations
Acceptance of Engagement
The International Standard on Assurance Engagements no. 3400 states
that before accepting an engagement to examine prospective financial
information, the auditor would consider, amongst other things:
The intended use of the information;
Whether the information will be for general or limited distribution;
The nature of the assumptions, that is, whether they are best-estimate or
hypothetical assumptions;
The elements to be included in the information; and
The period covered by the information.
ISA 3400 adds that the auditor should not accept, or should withdraw
from, an engagement when the assumptions are clearly unrealistic or
when the auditor believes that the prospective financial information will
be inappropriate for its intended use.
(b)
(i)
(ii)
Accounting polices
Establish the accounting policies adopted for interim and final
accounts and forecasts. Ensure that they are reasonable and are
consistently followed especially in the forecasts. Special areas to
be watched include stock and work in progress valuations,
depreciation, the method of taking profit on long term contracts,
exceptional and extraordinary items and deferred tax.
(iii)
The assumptions
- These should be stated
- The forecast should be consistent with the assumptions which
may be economic (e.g. growth in G.N.P.), financial (e.g. interest
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179
INTRODUCTION
In accordance with our normal practice we wish to bring to your
attention certain matters that have come to our attention during our
interim audit visit. These do not represent an exhaustive list of all
weaknesses that may exist in the systems of accounting and
internal controls.
Our report is a draft report and we hope that you will review it and
append your management comments to enable us to finalise our
report.
2.0
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2.1
Credit limits
We noted that the credit limits for four customers have been
substantially exceeded and that new customers in the last twelve
months had not been allocated credit limits.
Enforcing credit limits reduces the incidence of bad debts.
Conversely when credit limits are exceeded or not established the
companys liquidity position is adversely affected.
We recommend that credit limits be carefully established and then
once established they should be enforced. When necessary that the
limits be revised then proper formalities should be followed and
the extension be approved by senior management.
Management comment:
2.2
Purchases invoices
We came across a situation where an invoice from a supplier had
been posted twice to the suppliers ledger card.
We also were unable trace two other purchase invoices that had
been credited to suppliers accounts.
These discoveries raise the possibility that there a fictitious charges
and invoices being introduced into the system. The company runs
the risk of paying for services or goods not received not ordered
for
We recommend that for the acquisition of goods there must e
raised a purchase order, when the invoice is received it must be
checked against the purchase order and the goods received note
before it is entered into the records. All invoices should be
validated before payment and the cheque should be supported by
invoices. All claims that cannot be supported by invoices should
be rejected for payment.
Management comment:
2.3
(a)
(b)
(c)
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Management comment
2.4
Leasing agreements
The Kenya Revenue Authority have queried the terms of the
lease agreements. In their view these are hire purchase
agreements since the customers have the right to purchase
the equipment at a future date. We have vetted these
agreements in the past and agreed with your treatment. Our
position has not changed and we shall take it up with the
Kenya Revenue Authority.
The risk is that additional assessments may be raised by the
Kenya Revenue Authority.
We recommend that the chief accountant immediately
commence an analysis exercise of the position depending on
the two different scenarios. In this way we will be able to
assess the exposure.
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Management Comment
3.0
Conclusion
These are the weaknesses that came to our attention. There
may be other weaknesses that we did not detect. We request
that you critically consider these points and append your
comment where indicated on the draft.
Having incorporated your comments we will then release the
letter formally.
The possible impact these matters may have on the year end work
(i)
The concern over credit limits being exceeded or not fully enforced
means that audit effort must focus on the adequacy of the provision
for bad and doubtful debt at the year end audit visit as well
considering the companys overall financial position, particularly
insolvency.
(ii)
(iii) The valuation and existence of stocks at the year end will be key
areas of audit.
(iv)
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ANSWER THREE
(a)
(i)
(ii)
As such audit effort will be focused on the existence of the stocks and the
adequacy of the provision for obsolete, damaged and slow moving stock
items.
(iii)
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Final
Before signing the auditors report the partner responsible will
perform a final review. This will involve:
Ensuring that all audit work has been completed and the evidence
is sufficient to support the expression of an opinion
Ensuring that the view shown by the accountants as a whole is true
and fair for this deal with
Accounting policies
General review
Presentation and disclosure
Compliance with regulation
Conclusions
185
General Review
It is important to conduct a final analytical review on the accounts in their
format for publication. This includes analytical reviews and other review.
Presentation and Disclosures
When the accounts are in the format in which they are to be presented to
shareholders the auditor must look at the presentation as a whole. This
will include in particular, the working of notes and other descriptive
disclosures. Most of the audit effort will have been devoted towards
verifying the numbers yet the impression conveyed by the accountants
depends as much on the presentation as on the numbers themselves. The
auditor must be satisfied that the impression a reader would obtain from
the accounts is consistent with the conclusions reached in the audit. The
presentation should not be unduly influenced by managements desire to
show matters in a favourable or unfavourable light.
Compliance with regulations
Most auditors use a checklist to confirm that all matters required to be
disclosed by the Companies Act and by IASs and other applicable
regulations are properly dealt with in the accounts with respect to the
Companies Act. Disclosure requirements are contained in: Schedule 6
particulars in company accounts dealt with and other transactions
favouring directors and offices.
Conclusion
Answers
186
(c)
(d)
(e)
(f)
187
All is well or
Further audit evidence is required in some areas or
That it may be desirable to make amendments o the accounts and
That a qualified report may be required
188
(iii)
(iv)
(v)
(vi)
(vii)
Answers
Consistently applied over the years within the enterprise
Consistently applied throughout the enterprise
Appropriate and applicable to the particular circumstances
In compliance with relevant IAS
Adequately disclosed in accordance with IAS 1 and the framework
for the preparation and presentation of financial statements.
(ii) This policy is not commonly adopted within the industry in which
you operate.
We recommend that the contract revenue is credited to the profit
and loss of account over a three
year period, based on the proportion of the actual cost incurred
during each year.
For the financial statements to give a true and fair view we further
recommend that the amount of contract revenue taken credit for any one
year be separately disclosed as a note to the financial statements, sot that
the reader of the accounts can determine:
189
190
Answers
(vi)
(i)
(ii)
(iii)
(iv)
(v)
191
(vi)
Answers
192
DECEMBER 2003
QUESTION ONE
(a) For the assignment to be completed in the specified time restriction
the client will take the following steps:
Ensure that all employees affected by the audit are aware
The books of account should be up-to-date so that the auditor will
not be delayed
An interim audit should be undertaken to ensure that work that can
be done early is done.
The following key audit tasks will be undertaken during the
interim audit.
(b) Steps to be taken by the auditor
Adherence to deadlines in the audit process
Use more experience staff
Perform most of the work during the internal audit
Group accounting issues should be dealt with early in the process
Quality assurance procedures should be adhered to.
ANSWER TWO
For many businesses, sales are made on credit and thus the sales cycle
includes control objectives for receivables. These controls objectives
include:
(a)
(b)
(c)
(d)
193
(e)
(f)
Answers
194
(a) Orders
(i) The orders should be checked against the customers account; this
should be evidenced y initialing. Any new customers should be
referred to the credit control department before the order is
accepted.
(ii) Existing customers should be allocated a credit limit and it should
be ascertained whether this limit is to be exceeded if the new
order is accepted. If so the matter should be referred to credit
control.
(iii) All orders received should be recorded on pre-numbered sales
order documents.
(iv) All orders should be authorized before any goods are dispatched.
(v) The sales order should be used to produce a despatch note for the
goods outward department. No goods may be despatched without
a dispatch note.
(b)Despatch
(i) Dispatch notes should be pre-numbered and a register kept of
them to relate to sales invoices and orders.
(ii)
195
(iv) All invoices and credit notes should be serially pre-numbered and
regular sequence checks should be carried out.
(v)
(vi)
(d)Returns
(i) Any goods retuned by the customers should be checked for
obvious damage and, when accepted, a document should be
raised.
(ii) All goods returned should be used to prepare appropriate credit
notes.
(e) Receivables
(i) A receivables ledger control account should be prepared regularly
and checked to individual sales ledger balances by an independent
official.
(ii) Receivables ledger personnel should be independent of dispatch
and cash receipt functions.
(iii) Statements should be sent regularly to customers.
(iv) Formal procedures should exist for following up overdue debts
which should be highlighted either by the preparation of an aged
list of balances or in the preparation of statements to a customers.
(v) Letters should be sent to customers for collection of overdue
debts.
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197
invoices and credit notes. This last test will also serve as a
substantive procedure.
(d) Check dispatch notes and gods returned notes to ensure that they
are referenced to invoices and credit notes and vice versa.
(e) Check that control account reconciliation have been performed
and reviewed.
Reper form the control by checking the
reconciliation to source documentation.
(f) Ensure that batch total controls have been applied by seeking
signature and tracing batches from input to output.
In all cases, test should be performed on a sample basis. The auditor
should investigate errors and consider the need for further testing to
obtain comfort on the proper application of the control procedures.
QUESTION THREE
(a)
The proposed takeover will have an impact on the audit approach because
management will be under pressure to portray the performance of the
company in a better picture in order to raise the takeover price; Earnings
management is a significant audit risk in the case of Tex Ltd.
Provisioning is an area where management may try to manipulate in
order to increase reported profits.
Therefore since the risk of
management override of controls is likely, substantive auditing is testing
will be key in the audit approach.
For the item sundry accruals and provisions all the figures are materially
lower in the current financial period hence the reasons for the changes
must be sought and the auditor must be alert for other area where creative
accounting may be utilized to boost profits such as capitalization of
revenue expenses or failure to recognize asset impairments.
I will also be alert for evidence of fraud since it is apparent that the
management is already biased.
(b)
1.
Sundry accruals
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Answers
(i)
Accounting Treatment
According to IAS 37, accruals are liabilities to pay for goods or
services that have been received or supplied but have not been
paid, invoiced or formally agreed with the supplier, including
amounts due to employees accruals are often reported as part of
trade and other payables where provisions are reported separately.
According to IAS 1, presentation of financial statements, states
that all items of income and expense should be included in the
profit or loss account, unless another standard requires otherwise.
Therefore the above accounting treatment for sundry expenses is in
accordance with accounting standards.
(ii)
(iii)
Additional Work
- A sample of the amounts below Shs. 100,000 should be taken
and evaluated in details.
- Cut off procedures for the expenses should also be evaluated
and the documentation for the accruals immediately before and
after the balance sheet date verified.
2.
199
Accounting Treatment
Provision for major maintenance should not be recognized
and the whole amount should be written back to the profit
and loss account. I disagree with the accounting treatment.
(ii)
Audit Work
The audit work done is not adequate due to the impact of the
decrease on reported profits and its implications on the
integrity of management as well as the reliability of
management presentations.
(iii)
Answers
200
Audit Work
The supporting documents of 21% of the total amount of
maintenance provision seen is not adequate audit work. The period
and reasons as to why the large provision was created needs to be
verified.
Audit work should be geared towards the objective of the
provision, was it ignorance of accounting requirements or was it
attempted fraudulent financial reporting.
(iii)
Additional Work
- Enquire from management why the provisions were created and
whether they were aware that it is against accounting standards.
- Verify previous period maintenance costs and whether they are
reasonable compared with the current period.
QUESTION FOUR
(a) (1)
Methods that would have been used to overstate the profits.
The methods used to overstate profits for the year ended 31 October 2003
can be categorized into:
(i) Exploiting loop holes in the applicable financial reporting
framework.
(ii) Fraud or intentional misrepresentation:Examples of these methods include:(i) Unsuitable revenue recognition procedures in contravention of
IAS 18, Revenue.
(ii) Manipulation of management estimates such as required by IAS
36, impairment of assets, which requires recognition of assets
impairments as expenses.
The process of preparing, financial statements requires
management statements requires management judgements with
regard to the carrying amounts of assets.
201
(iii)
Generous reserve accounting or big-bath provisioning in previous
periods which are reversed in the accounting period.
(iv) Failure to recognize appropriate provisions in accordance with
IAS 37, this would result in reduced costs.
(v) Improper application of accounting policies with regard to
valuation of inventories as per IAS 2, inventories. The
management may fail to recognize stock write downs. This
affects the closing stock figure hence increasing profits.
(vi) Changes in accounting estimates intended to lower charges for
depreciation.
(vii) Recognition of fictitious sales in order to boost profitability.
(viii) Capitalization of revenue expenditures.
(ix) Off balance sheet financing through unconsolidated
subsidiaries.
(x) Transactions with related parties with no economic substance or
merit.
(b)(i) Unsuitable revenue recognition procedures
- Inquire managements policy with regard to revenue recognition.
- Evaluate the internal control on revenue recognition and sales.
- Test cut off procedures to ensure sales are recognized in the
correct period.
(ii)
(iii)
(iv)
Answers
202
(vi)
(x)
203
204
Answers
the non compliance so as to call into question the time and fair
view given by the financial statements.
- I would seek permission from Mr. Craig to discuss with his
lawyer the implications.
- I would also consult with my own lawyer to discuss the
possible legal consequences and the action I should take.
- Consider withdrawing from the engagement.
(b)
If my firm was doing the audit for the first time, I would consider
the reputational risk posed by associating with Mr. Craig to our
firm and seek legal advice.
I would discuss with the risk partner in our firm and withdraw
from the audit if Mr. Craig has not undertaken corrective action.
If Mr. Craig does not adjust the financial statements and
underlying records, I will withdraw from the engagement, seek
legal advise.
(c)
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JUNE 2004
QUESTION ONE
Managing Director,
Tropical Garments Ltd.,
P.O. Box 2411 K.N.H., 00202
Nairobi.
Dear Sir,
Re:
(ii)
(iii)
(iv)
(v)
(vi)
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Answers
The above components of the internal control system will ensure that the
payments of weekly wages objectives are achieved.
Specific Control Procedures include:
There should be written authorization to employ or dismiss any
employee, in accordance with company procedures and legal
requirements.
Changes in rates of pay or salary should be authorized in writing
by an official outside the wages department. This may be through a
standard form for authorization of changes to payroll details.
Overtime worked should be authorized by the works manager or
employees manager or someone outside of payroll and be in
accordance with company procedures. Some staff may not be
entitled to overtime because of their level or type of employment
and therefore appropriate mechanisms for ensuring only authorized
staff receive overtime.
An independent official should check the payroll and sign it.
The wages cheque should be signed by two signatories evidenced
against the signed payroll. Cheques should have two signatories
and should be checked against an approved payroll entry.
Where pay relates to hours at work, some form of time recording
should be used for example; time keys, automatic entry swipe card
systems or other clock cards should be used. There should be
supervision of the time recording systems or cards and the timing
devices, particularly when employees are clocking on or off. There
is a clear risk that staff can manipulate systems to obtain additional
hours and therefore additional payments. This could include
getting other staff to clock in or out for them. The manager or
supervisor should know the hours worked by staff and check
outputs to ensure that expected and actual hours tally.
When employees have been absent for a significant period their
entitlement to salary should be checked against personnel details.
207
Answers
208
209
Answers
210
QUESTION TWO
Potential Risk
1. Financial reporting risk
Audit Procedures
1. Review the transactions between
MPH and RS
2. Foreign operations risk
2.
Review currency exchange
rates.
3. Exchange risk
3.Reviewthe translation exercise
4. Related party transactions 4.
Request for a letter of
resulting in misrepresentation
representation showing details and
disclosures are appropriate
5. Pension fund not being able to 5. Review the basis on which the
pay benefits
surplus was determined. Consult
actuaries
6. Inadequate provisions to boost Review cut off procedures for sales
profits
and purchases
QUESTION THREE
Tutorial Note: This question deals with the audit of stocks
(i)
(ii)
(iii)
(i)
(ii)
(iii)
(iv)
(v)
(b)
(vi)
211
(iii) Goods returned to suppliers prior to the year end are excluded
from stock and trade creditors.
At the year end stock take the auditor will have made a note of the last
serial numbers of goods received notes.
Suggested substantive
procedures are as follows:
(a) Check from goods received notes with serial numbers before the year
end to ensure that invoices are either
(i) Posted to purchase ledger prior to the year end; or
(ii) Included on the schedule of accruals
(b) Review the schedule of accruals to ensure that goods received after
the year end are not accrued
(c) Check from goods returned notes prior to year end to ensure that
credit notes have been posted to the purchase ledger prior to the year
end or accrued
(d) Review large invoices and credit notes included after the yearend to
ensure that they refer to the following year
(e) Reconcile daily batch invoice totals, around year end to purchase
ledger control ensuring batches are posted in the correct year.
(f) Review the control account around the year end for any unusual
items.
Evidence of completeness, existence and ownership credit
circularization
We have established that the verification of trade debtors by direct
communication is virtually a standard procedure. Is it therefore also
standard procedure to carry out a creditor circularization? The answer is
qualified No. The principal reason for this lies in the nature of the
purchase cycle third party evidence in the form of suppliers invoices
and even more significantly suppliers statements are part of the standard
documentation of the cycle. He auditor will hence concentrate on these
documents when designing and conducting his test to gain assurance in
respect of objective Do trade creditors represent bonafide amounts due
to the company.
In the following circumstances the auditor may, however, determine that
a circularization is necessary
(i) Where suppliers statements are, for whatever reason, unavailable or
incomplete.
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Answers
213
8
640
=
8
If I am replaced as the auditor I will seek legal advice and advise the
client to streamline the operations and do everything correctly.
Since the Managing Director is the majority shareholder this will prevail
(iii)
(iv)
I would report and explain the fraud to the audit committee since
the Managing Director is a minority shareholder, the other
directors will impress upon him that the fraud should be reported.
The Managing Director is likely to agree to amendments of the
accounts because adverse publicity is very serious for a listed
company.
Answers
214
(i)
(ii)
(iii)
(c)
215
DECEMBER 2004
QUESTION ONE
(a) The general access controls will include both physical controls and
programmed access controls.
The computers should be kept in rooms with restricted access.
Only authorised personnel should have access.
When the computers are unattended relevant programs should not
be left running.
That the terminals will be . linked to the mainframe computer
through a dial up link means that the machines communicate
through a telephone line. This means that there is a danger that
communication between the computers could be interpreted and
transmission intercepted without proper authority. Therefore I
would expect that built into the system would be the provision of
a dedicated line at Mwebeni Ltd. such that when the mainframe
computer receives a signal from a terminal it will not accept
instructions directly rather it would call back at the dedicated
number at. to facilitate the dial up link.
All authorized users should have been issued with passwords or
some other form as identification such that once the dial up link
has been facilitated the system should demand for a password
which must be keyed in. In this way different levels of access can
be given to the staff e.g. the purchases ledger clerk can access the
system for reading purposes only without the authority to effect
any transfers.
The password has to be keyed in for the computer to determine
the degree of access the password holder is permitted.
The system should have been programmed that transfers can only
be effected at certain times like between 11 a.m. and 3 p.m. on a
working day. When any attempt is made to effect transfer the
system checks against its in built clock and confirm that time
access is being attempted is reasonable.
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Answers
A comprehensive creditors master file should have been built up
with all details of the creditors bank and the account number at
that bank. These details would have to be keyed in when a
transfer is to be made. The creditors master file must be on line
when transfers are being effected so that the sytem automatically
performs a master file check to ensure that the company does
have such a supplier. At the same time the programme would also
perform a reasonableness check that the proposed amounts to be
transferred do not exceed the amount due to that supplier.
Both ends of the system should have been programmed to
automatically prepare a record of the transfers that have been
effected.
A limit should have been built into the ystem such that only
transfers below this amount should be effected by line system,
any amounts in excess should be rejected requiring a cheque
signed by the authorized signatories.
A requirement should have been in place that passwords should
be changed regularly. There should have been built into the sytem
to deny access or refuse to act on the instructions of password
users who has not changed their password within the stipulated
time.
Should have built into the system a ,mechanism for the system to
close down automatically if a wrong password is entered more
than 3 times.
Similarly it should close down it require the password to be keyed
in again if no activity takes place when the 2 machines are linked
for a period of time, say 5 minutes.
Should have built into the system a mechanism that informs the
mainframe computer the number of transfers to be effected so that
once many transfers have been effected the dial up link is
immediately disconnected.
217
Answers
218
(ii)
(iii)
(iv)
(v)
219
(vi)
220
Answers
management intends to liquidate the enterprise or to cease trading, or
has no realistic alternative but to do so. When management is aware,
in making its assessment, of material uncertainties related to events
or conditions which may cast significant doubt upon the enterprises
ability to continue as a going concern, those uncertainties should be
disclosed. When the financial statements are not prepared on a going
concern basis, that fact should be disclosed, together with the basis
on which the financial statements are prepared and the reasons why
the enterprise is not considered to be a going concern.
In assessing whether the going concern assumption is appropriate,
management takes into account all available information for the
foreseeable future, which should be at least, but is not limited to,
twelve months from the balance sheet date. The degree of
consideration depends on the facts in each case. When an enterprise
has a history of profitable operations and ready access to financial
resources, a conclusion that the going concern basis of accounting is
appropriate can be reached without detailed analysis. In other cases,
management may need to consider a wide range of factors
surrounding current and expected profitability, debt repayment
schedules and potential sources of replacement financing before it
can satisfy itself that the going concern basis is appropriate.
In planning the audit, the auditor should consider whether there are
events or conditions which may cast significant doubt on the entitys
ability to continue as a going concern.
The auditor should remain alert for evidence of events or conditions
which may cast significant doubt on the entitys ability to continue as
a going concern throughout the audit. If such events or conditions are
identified, the auditor should, in addition to performing the procedures
221
222
Answers
223
224
ii.
Answers
Assisting directors (particularly non executive directors) in
meeting their responsibilities in respect of financial
reporting
Strengthening the independent position of a companys
external auditor by providing an additional channel of
communication.
iii.
(c)
225
management.
The notion that the non-executive
members of the audit committee can be suitably
independent may be difficult to achieve.
Ideally the audit committee should comprise of persons
who have a suitable range of professional and business
skills, sufficient knowledge of the business and yet have
not developed close relationships with the main board.
They should have had no recent actual movement with
the direct management of the organization, thus their
judgment should be impartial free from influence and
therefore unbiased.
c) The ban on advertising accountancy services in Kenya is not
sustainable.
Developments in the developed countries have led to accountants
advertising their services in several countries.
The arguments for advertising include:
Increasing awareness of the services provided by accountants hence
increasing business
Eliminating the quacks or those who are not licensed because the
public will know who is licensed and who is not.
Giving clients a wide choice
Enhancing competition hence leading to provision of higher quality
services at lower costs and making the services of accountant more
affordable to small enterprises.
However it has been argued that advertising will lead to unfair
competition and unethical adverts claiming superiority over others. This
would dent the image of the profession.
However these events have not occurred in these countries which
advertise and therefore since the movement globally is towards
advertising it probably a matter of time before advertising is allowed in
Kenya.
Failure to make it legal will only promote unethical non standardized
process which will actually damage the reputation of the profession.
c) Specific Actions which firms can take to minimize audit risk
Incorporation into limited liability companies where the laws allow
Introducing disclaimers in their audit reports and limiting the
circulation
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226
QUESTION FIVE
REGULATION AND PROFESSIONALISM
Kenya answer tips
Part (a) is largely factual and tests your knowledge of the current
regulatory framework as it applies to fur aspects of auditing. Revise
your knowledge on these fundamental areas if necessary they are al
fundamental to your study of auditing.
Part (b) asks you to discuss. Your ideas and views are being looked for
here. This type of question shows the importance of students being
aware of the debating points affecting the profession jot down some
ideas on this, (what have you covered on your course? What have you
seen in the media? What is discussed in your office?) before attempting
your answer. Note that his part of the question carries only 8 marks.
The purpose of this question is to examine students on current and
potential changes in practice within the profession.
(a)
(i)
227
(iii)
228
Answers
For example if he recruits key financial and administrative staff,
it could be construed as the performance of a management
function. The auditors objectivity may be threatened in such
situation and he should be careful that he is not seen as acting
as anything other than an independent adviser.
(iv)
(b)
(i)
(ii)
It is quite apparent from the press and audit research that the
public believe that the auditor should and in fact does search for
fraud during the conduct of an audit. In view of the recent
scandals, particularly BCCI and the Maxwell affair, the public
expectation of the extent of an audit has increased.
It is not surprising, given the nature of these scandals that the
public finds it difficult to accept that an auditor has no
responsibility for the detection and reporting of fraud,
especially when one sees the high social cost of these scandals.
(iii)
229
(iv)
It has been argued that the long term nature of the company
audit engagement can lead to a loss in auditor independence due
to an increasingly familiarity with the companys management.
Answers
230
JUNE 2005
QUESTION ONE
The Managing Director
Motor Fit Ltd
P O Box 2411
00202 NAIROBI
7 June 2005
Dear Sir
Suggested steps to be taken to reduce time spent on audit work for
current year ending 30 September 2005
I refer to your letter dated 7 May 2005 raising issues regarding the costs
of the audit.
We have carried out a review of the major factors or determinants of
costs of the audit and since our billings are based on the time spent on the
audit, we may be able to reduce audit costs.
i) The role of an auditor is to express an opinion on the financial
statements. It is the responsibility of management to prepare financial
statements in accordance with the identified financial reporting
framework.
We have been preparing the financial statements for your company.
We suggest that the company prepares the financial statements in
accordance with the IFRS so that we shall not need to spend any more
time on them.
We review our letter of engagement.
ii)
231
iii)
Delays in preparation of the final management accounts necessitated the
addition of an extra member of staff to meet the deadline imposed on
us by the company.
We suggest timely completion of the management accounts. This can
be achieved by increasing the number of members of staff of the
accounts department.
iv)
The company has increased in size and a number of the locations are
separate subsidiaries. We suggest that the audit work at the
subsidiaries can be done by other competent firms in those areas. We
shall definitely evaluate our reliance on their work.
v)
vi)
Maungu & Co
Certified Public Accountants
QUESTION TWO
(a) Definition of assurance engagement and its purpose.
232
Answers
233
Answers
234
Acquisition of companies;
Purchase of business;
Prospective investments;
Admission of new partners
Prospective lending;
Fraud;
Systems breakdown;
Company acts investigation;
235
banks, local authorities, the tax authorities can all commission various
investigations.
Investigations: the stages
All investigations are carried out in the same way.
Stage 1:
You must always obtain precise written instructions from the client. This
must incorporate a very clear view of the aims of the investigation, the
scope of the investigation, the degree of the detail required, the degree of
secrecy to be observed, and the person to whom the accountant must
address his report. At this level, consideration must be given to the
resources the client is ready to utilize and the cost of the job, both in
terms of money and time.
Stage 2. Professional courtesies
Professional etiquette requires that if investigations are carried out in the
affairs of organizations to whom the accountant is not the auditor then the
auditors must be communicated with. This is to observe the usual
courtesies and to obtain their cooperation.
Stage 3: organization of the investigation
This involves the accountant assessing the aims of the investigation,
estimating the time to be taken and the likely costs and ensuring that the
appropriate staff will be available.
Stage 4: obtaining the background information
This is particularly important in investigations in acquisition of business.
It involves gathering as much background information as possible about
the object of the investigation, the size of the industry and its structure,
history since commencement, the future prospects, the relevant
legislation affecting that industry, investment information and relevant
accounting ratios. This information is usually available from published
sources such as government statistics, trade associations and the financial
statements.
Stage 5: gathering preliminary information
This information has to be gathered on the subject to be investigated. This
information includes the location of the subject, its products, its range of
Answers
236
services and its share of the market, key personnel, major accounting
control systems and past reports.
Stage 6: preparing the report outline
A report that meets the needs of many accounting investigations
is as follows:
Part A:
introduction whereby we have references to the instructions
given. The object of the investigation must be apparent from the
introduction.
Part B:
Part C:
the report
Part D:
a statement of the scope of investigation stating the time,
period and the area covered
Part E:
a statement of the documents use. If it is necessary to
reproduce any of these documents this is usually done in an
appendix.
Part F:
an outline of the work actually done, again it may be
necessary to put some of this material in an appendix.
Part G:
Part H:
further information which could be of use to the client but
does not flow from the investigation proper.
Part 1:
Recommendations of the accountant. In giving
recommendations, the accountant must always ensure that:
j) He gives information from which the client can draw
his own conclusions
k) Avoid presenting information in such a way that the
clients judgment is influenced.
l) If information is based upon assumptions, then the
accountant must state the assumptions in full and
substantiate them if possible.
m) Make no forecasts
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Stage 9:
238
Answers
QUESTION FIVE
(a)
Work expected to be carried out by the
internal auditors of UPS hotel Ltd.
ISA 610 defines internal auditing as a means of appraisal activity
established within an entity as a service to the entity. Its function
includes among other things, monitoring internal control.
The scope and objectives of internal auditing vary widely and depend
on size and structure of the entity and the requirements of its
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240
Answers
The work is performed by persons having adequate technical
training and proficiency as internal auditors and the work of
assistants is properly supervised, renewed and documented.
Sufficient appropriate audit evidence is obtained to be able
to draw reasonable conclusions
Conclusion reached are appropriate in the circumstance and
any reports prepared are consistent with results of the work
performed, and
Any exception or unusual matters disclosed by internal
auditing are properly solved.
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DECEMBER 2005
QUESTION ONE
(a)
i)
ii)
iii)
iv)
How
program may assist in circularisation of debtors.
computer
242
Answers
i)
ii)
iii)
iv)
v)
243
244
Answers
245
x)
Intimidation threat occurs when a member of the assurance team may
be deferred, from acting objectively and exercising professional
skepticism by threats, actual or perceived, from the directors,
officers or employees of an assurance client.
QUESTION THREE
(a) Verification that school fees are paid to authorized schools and the
existence of students.
i) Obtain a list of authorized schools and ensure that all payments of
school fees were only made to schools authorized by the trustees.
ii)
iii)
iv)
v)
vi)
246
Answers
occurrence,
vi)
vii)
viii)
ix)
To determine that all investment income had been properly recorded, the
auditors would carry out the following work;
i) Check in stock exchange lists or company accounts in respect of
unquoted companies to determine the dividends that should have
been received in the period.
ii) Obtain information on all bonus and rights issues during the year
and investigate action taken and shares received.
247
iii)
Check that the interest due is received on the due date and that it relates
correctly to the nominal value of the security
iv) Verify the correctness of calculation and recording of capital gains
and losses and their treatment in the financial statements.
v) Review the reasonableness of investment income accounts, taking
into consideration the amounts budgeted for and the amounts
received in previous year. Material variations would need to be
explained, taking into account purchases, bonus issues and sales in
the period.
(c) Verify the ownership of fixed interest investments and the shares in
listed companies.
i)
ii)
iii)
iv)
v)
248
Answers
QUESTION FOUR
(a)
BCD
Stores Ltd is a high risk audit client in view of the problems
associated with
i) Inventory misappropriation by employees and customers
ii) Slow moving and damaged goods, work less than cost.
iii) Incomplete recording of sales when customers pay by cash
The above are areas of high audit risk and as the manager responsible
for the audit, I would consider the following matters and carry out the
necessary audit work before the commencement of detailed audit
work;
Matters to be considered;
i) The significance and materiality of the audit risk areas
ii) The relevance of the knowledge gained in previous audits and
whether any changes have occurred that may affect the relevance
of the information to the current audit
iii) Since BCD has high audit risk areas, I will consider the following
logistical issues
- Staffing of the audit level of qualification, relationship with
audit staff, availability, special correct level of experience
- Client management
- Locations of the client considering distance to be travelled by
audit staff, mobility, determine which location to visit, staff
allocations.
- Deadlines, considering the key dates which the audit team will
need to know such as date of inventory count, main audit visit,
reviews by managers, draft accounts, date when audit report is
signed and date of AGM.
iv) Consider the use of information technology
v) Consider time budgets
vi) Consider other objectives of the audit in addition to the expression
of an opinion.
The audit work to be carried out includes;
i) Review client acceptance and continuance relationships and for
this specific audit engagements and ethical clearance.
ii) Determine adequate staffing of this audit assignment
iii) Hold meetings to discuss the risk of material misstatement in the
areas of risk and its implications for the financial statements.
249
iv)
Determine an appropriate audit strategy. In this audit, a combination of
tests of control and extensive substantive testing will be required
v) Review stock taking instructions by the client for adequacy,
staffing of the stock take and recommend changes as appropriate.
vi) Review stock taking procedures for identifying obsolete and
damaged stock
vii) Discuss with the client and the audit staff to agree on timings for
interim vist, final visit and stock take data.
viii) Allocate adequate resources for this audit
ix) Prepare the overall audit strategy and audit plan, document it and
communicate with the relevant audit staff
x) Review the internal audit, and decide whether to rely on its work.
(b) Procedures to be carried out to control the audit
i) Communication to the audit staff of the engagement details and
ensuring that all logistical arrangements are complete
ii) Ensure that staff follow the detailed audit plans especially in the
high audit risk areas.
iii) Review the audit plans and the ICE and ICQs for completion
iv) Consult as necessary with the engagement partner and the clients
management in case of any difficulties.
v) Ensure that stock taking instructions are followed, be present at
some locations during the stock take and ensure that I test the
stock sheets for accuracy.
vi) Review the work done by the internal audit department if we
decided to rely on it.
vii) Ensure that deadlines are being met and if not, consult with the
client and engagement partner.
QUESTION FIVE
(a) Respective responsibilities of directors and management of a company
and its external auditors with respect to financial statements.
ISA 200, explains the respective responsibilities.
The responsibility for the preparation and presentation of the financial
statements in accordance with the applicable financial reporting
framework is that of the management of the entity with oversight from
those charged with governance.
The auditor is responsible for forming and expressing an opinion on
the financial statements.
Answers
250
251
QUESTIONS - MOCKS
MOCK ONE
QUESTION ONE
Hydrasports, a limited liability company and national leisure group, has
sixteen centers around the country and a head office. Facilities at each
centre are of a standard design which incorporates a heated swimming
pool, sauna, air-conditioned gym and fitness studio with supervised
childcare. Each centre is managed on a day-to-day basis, by a centre
manager, in accordance with company policies. The centre manager is
also responsible for preparing and submitting monthly accounting returns
to head office.
Each centre is required to have a licence from the local authority to
operate. Licences are granted for periods between two and five years and
are renewable subject to satisfactory reports from local authority
inspectors. The average annual cost of a licence is Kshs.90,000.
Members pay a Kshs.1,000 joining fee, plus either Kshs.500 per month
for peak membership or Kshs.300 per month for off-peak, payable
quarterly in advance. All fees are stated to be non-refundable.
The centre at Verne was closed from July to September 2003 after a
chemical spill in the sauna caused a serious accident. Although the centre
was re-opened, Hydrasports has recommended to all centre managers that
sauna facilities be suspended until further notice.
In response to complaints to the local authorities about its childcare
facilities, Hydrasports has issued centre managers with revised guidelines
for minimum levels of supervision. Centre managers are finding it
difficult to meet the new guidelines and have suggested that childcare
facilities should be withdrawn.
Staff lateness is a recurring problem and a major cause of early bird
customer dissatisfaction with sessions which are scheduled to start at
07.00. New employees are generally attracted to the industry in the shortterm for its non-cash benefits, including free use of the facilities but
leave when they require increased financial rewards.
Training staff to be qualified life-guards is costly and time-consuming
and retention rates are poor. Turnover of centre managers is also high,
due to the constraints imposed on them by company policy.
Questions - Mocks
252
Three of the centres are expected to have run at a loss for the year to 31
December 2003 due to falling membership.
Hydrasports has invested heavily in a hydrotherapy pool at one of these
centres, with the aim of attracting retired members with more leisure
time. The building contractor has already billed twice as much and taken
three times as long as budgeted for the work. The pool is now expected to
open in February 2004.
Cash flow difficulties in the current year have put back the planned
replacement of gym equipment for most of the centres.
Insurance premiums for liability to employees and the public have
increased by nearly 45%. Hydrasports has met the additional expense by
reducing its insurance cover on its plant and equipment from a
replacement cost basis to a net realisable value basis.
Required:
(a) (i) Identify and explain the business risks which should be assessed
by the management of Hydrasports.
(8 marks)
(ii) Explain how each of the business risks identified in (i) may be
linked to financial statement risk.
(8 marks)
(b) Describe the principal audit work to be performed in respect of the
carrying amount of the following items in the balance sheet of
Hydrasports as at 31 December 2003:
(i) deferred income; and
(3
marks)
(ii) Hydrotherapy pool.
(3
marks)
(c) Suggest performance indicators that could be set to increase the
centre managers awareness of Hydrasports social and environmental
responsibilities and the evidence which should be available to
provide assurance on their accuracy.
(8
marks)
(Total: 30 marks)
QUESTION TWO
Taurus Traders
253
254
Questions - Mocks
Mr. Aquila is negotiating a bank loan to finance the cost of planned new
premises. Contracts with the builders have been signed and building
work has commenced. The bank is waiting for a profit forecast before
giving final approval to a Kshs.2 million loan.
Taurus traders has increasingly tended to exceed its agreed overdraft
facility. Mr. Aquila has indicated that a large receipt from a major
customer, expected at the end of next month, is to be used to clear tax
payment arrears and repay his loan account of Kshs.52,000.
Mr. Aquila is recently married and has purchased a luxury apartment and
a new car. He is dissatisfied with the firm of accountants which currently
prepares and audits the annual financial statements. He attributes this is
to the firms failure to reconcile the ledgers. He also claims that the firm
has been unable to suggest how his remuneration package can be
increased to meet his personal needs.
Required:
(a) Identify and describe the principal business risks relating to Taurus
Traders.
(11
marks)
(b) Identify and comment on the factors that should influence the partner
in deciding whether or not the firm should make a proposal for this
engagement.
(5 marks)
(c) Justify an appropriate audit strategy for the first audit of Taurus
Traders.
(6 marks)
(d) Suggest two procedures that Taurus Traders could implement
immediately to improve its accounting procedures and financial
controls.
(3 marks)
(Total: 25
marks)
QUESTION THREE
You have been approached for advice by the financial director of Image
Ltd., a company which sells, rents and services photocopies and facsimile
machines. All the companys significant accounting applications are
processed on its own minicomputer.
255
During the preliminary investigation you established that all service calls
are logged on sequentially numbered dockets which bear the date of
service, time taken, material used and the serial number of the unit
repaired.
All details on the docket are captured into the service call billing system.
Billable service calls are identified by the relevant service engineer prior
to capture by marking the docket following a manual review of the rental
contracts file.
Service calls in respect of rented equipment are provided free of charge.
All other services are billable.
The system produces invoices for all service calls identified by the
service engineers.
You have been informed that the companys computerized customer
rental file contains full details of each rental contract, including
equipment serial numbers and rental start and end dates.
A transaction file which records each service call docket for the period
under review is retained by the computer department.
The transaction file includes fields which record the billable value of
every service docket and an invoice number for those dockets that were
invoiced to customers.
Required:
(a) List the main steps to be executed by means of a computer program in
order to identify and report service call billing errors by Image Ltd.
The program should identify errors that may arise as a result of
incorrect identification of billable service calls by the service
engineers. Your answer should make reference to appropriate files
and fields.
(You are not required to write the computer program)
(10
marks)
(b) List the procedures that should be followed by business with
significant in house information systems resources to ensure that all
changes
to
programs
are
properly
controlled.
(15 marks)
(Total: 25 marks)
QUESTION FOUR
a) Explain the role of support letters (also called comfort letters) as
evidence in the audit of
Questions - Mocks
256
financial
(5 marks)
statements.
257
This includes current taxes on profit and other taxes such as taxes
on capital. No provision is required to be made for deferred
taxation and its is impracticable to quantify the financial effect of
unrecognized deferred tax liabilities
Required:
Comment on the matters you should consider before expressing an
opinion on the consolidated financial statements of the Capri Group.
(10 marks)
(Total: 15 marks)
QUESTION FIVE
If there is a need for a uniform set of international accounting
standards and international auditing standards, there is also a need
for global corporate governance standards.
Required:
Discuss and reach a conclusion.
20 marks)
(Total:
Questions - Mocks
258
MOCK TWO
QUESTION ONE
Your firm has been approached by the managing director of Abacus
Leasing Ltd to tender for the audit. The previous auditors have resigned
after a loss of confidence in them by the board of Abacus Leasing Ltd.
This concerned the disapproval by the board of a qualified audit report
issued by the outgoing auditors, which referred to inadequate internal
controls in Abacus Leasing ltd systems.
The company leases equipment to building contractors, many of whom
have insufficient cash resources to purchase the equipment outright.
Some lessees have been refused credit elsewhere. Since formation three
years ago Abacus Leasing ltd turnover has doubled each year and lease
debtors now represent over 80% of the companys gross assets. The
company is now experiencing difficulty in collecting a substantial amount
of overdue lease payments. Abacus Leasing ltd has no formal system for
approval of new customers or any laid down procedures for the
repossession of assets where the terms of the lease agreements have been
broken.
Although the terms and conditions of the leases vary considerably Abacus
Leasing ltd has treated them all as finance leases.
The company is managed by a Board of three directors with a dominant
managing director who owns 95% of the share capital. The directors and
senior management are largely remunerated by a performance bonus on
new sales. The company does not have an audit committee.
Required:
(a)
(b)
(c)
The leases
(ii)
259
(Total: 20 marks)
QUESTION TWO
Midland Builders
An unmodified audit report normally states that the financial statements
to which the report refers give a true and fair view of the state of the
companys affairs at the balance sheet date and of is profits for the year
ended on that date.
Bearing in mind the above statement, the directors of Midland Builders, a
limited liability company, have drawn up accounts for the year ended 30
April 209x7 which do not reflect certain events which have occurred
since the year end. They justify their action on the grounds that the books
and records correctly reflect what was known at the year-end.
The following are the events which are not reflected in the draft financial
statements
( in all cases the figures are material).
(a) At a meeting in MAY 20X7 the local planning authority rejected the
companys plans to develop one of its freehold sites. The site was
included in the companys assets at its cost of Kshs.50,000 but it is
likely that the site will have to be sold and realize no more than
Kshs.35,000 because of its reduced development potential.
(b) Following the completion of a long term contract in June 20x7 it has
been possible to calculate the final profit on the contract. It appears
that the profit accrued at 30 April 20x7 was underestimated by
Kshs.20,000. This arose from material error at 30 April 20x7 in
estimating the amount of work still to be completed.
(c) A public company in which Midland Builders held shares as a long
term trade investment announced in June 20x7 that it was going into
liquidation. The investment is shown in the balance sheet at it
historical cost of Kshs.40.000 and a note of its stock market value at
30 April 20x7 of Kshs.46,000 is included in the notes to the accounts.
It now appears likely that the investment will prove worthless.
Required:
Questions - Mocks
260
(a) Discuss generally the effect which facts and events relating to a
period but becoming known or occurring after the end of an
accounting period can have on the financial statements for the period
in question. Comment on the directors view that the books and
record reflect what was known at the year end and that therefore no
further adjustments are required.
(b) List FOUR detailed procedures which an auditor should adopt in
order to detect events after the balance sheet date.
(c) In respect of each of the three event descried above, list the detailed
work which the auditor should undertake and comment on the
acceptability of the companys decision not to adjust its financial
statements.
(i) Refusal of planning permission
marks)
(ii) Completion of long term contract
(5 marks)
(iii) Liquidation of trade investment
marks)
(4
(3
(Total: 20 marks)
QUESTION THREE
Farrington Ltd
You are the manger in charge of the audit of Farrington Ltd. a company
which manufactures biscuits and confectionery. You wish to employ a
junior member of staff to audit the trade creditors, accruals and
provisions as shown in the balance sheet at the year end and are in the
process of preparing audit programmes which clearly explain the purpose
and extent of the work at each stage of the audit.
The draft figures for creditors amounts falling due within one year as
at 31 October 2004 (with 2003 comparative figures) are as follows:
31 October
2004
Kshs.
Trade creditors
177,625
Sundry accruals
18,177
2003
Kshs.
261,521
21,162
261
40,000
72,000
394,683
257,802
(8
(4
(Total: 16
marks)
QUESTION FOUR
Sampling
It is important to recognize that audit sampling may be constructed on a
non-statistical basis. If the auditors use statistical sampling, probability
theory will be used to determine sample size and random selection
methods to ensure each item or 1 in value of the population has the same
chance of selection. Non-statistical sampling is more subjective than
statistical sampling, typically using haphazard selection methods and
placing no reliance upon probability theory. However, in certain
circumstances statistical sampling techniques may be difficult to use. The
auditors will review the circumstances of each audit before deciding
whether to use statistical or non-statistical sampling.
Required:
Questions - Mocks
262
(a) List three situations where the auditors would be unlikely to use
audit-sampling tec
(b) Explain what you understand by the following terms
(i)
Attribute sampling
(ii) Monetary unit sampling
(c)
Orders the items from the sales department, which raises a pre
numbered multi copy advice note;
The dispatch department make up the order and give it to the
customer with a copy of the advice note;
The customer gives the advice note to the cashier who prepares a
hand written sales invoice;
The customer pays the cashier for the goods by cheque or in cash;
The cashier records and banks the cash.
For credit sales, cheques and cash are received in the post. The post is
opened by two people, who record cash and cheques received. The
cheques and cash are given to the cashier who records them in the
cashbook and pays them into the bank. The cashier reports the cheques
and cash received to the sales accounting department, which posts the
items to the sales ledger.
Credit notes must be authorized before they are sent to customers
and posted to the sales ledger.
263
Required:
(a)
State the weaknesses in the cash sales system
Describe the systems based tests you would carry out to check
there is no material fraud or error in this system.
(b)
Briefly explain why two people should open the mail, which
contains cheques and cash customers.
Describe the audit work you would carry out when you attend
the opening of the mail and follow through the process to
banking of the cheques.
(c)
List the reason why credit notes may be issued.
Describe the audit work you would perform to check that all credit
notes have been authorized and issued for a valid reason.
Questions - Mocks
264
MOCK THREE
QUESTION ONE
MEADOW
You are an audit manager in Robert Bracco, a firm of Chartered Certified
Accountants. One of your audit clients, Meadow, is a company listed on a
stock exchange with a 30 September accounting year end. The principal
activity of Meadow is retailing under the Vazandt brand name. The retail
industry has recently suffered from a reduction in consumer spending.
Meadow has two operating divisions: Domestic and International. Each
retail division is sub-divided into four business units: Ladieswear,
Menswear, Home furnishings and Foods. The International retail business
consists of three broad geographic areas: Africa, South America and the
Far East. Robert Bracco is represented by affiliated offices in allrelevant
countries.
You have obtained the following information from Meadows draft
financial statements:
(1) Financial extracts
30 September
Income Statement
Turnover
Total operating profit
1200
Provision for loss on operations
to be discontinued (Note i)
2001
Kshs
2,6388
1291
(838)
(47)
_______
406
(48)
_______
1152_
As at 30
September
Balance sheet
2001
2002
Kshs
Kshs
9505
265
4489
1642
225
537
Notes:
(i)
Operating
profit
2002 2001
2002
Kshs Kshs
Kshs
2001
Kshs
International
Africa
(118)
(90)
South America
111
53
990
967
2640 2505
266
Far East
28
(12)
Total International
21
(49)
Domestic
1270 1249
Total operating activities
1291 1200
Questions - Mocks
383
389
4013
3861
2,1837 2,2527
2,5850 2,6388
Number of stores
2002
International
Africa
South America
Far East
Total International
Domestic
Total
2001
4
86
4
104 104
107 106
211
13
87
4
210
267
You have been asked by the senior in charge of the audit of Ringham
Manufacturing ltd to describe certain aspects of the work you will carry
out in auditing the companys wages system. Employees of Ringham
Manufacturing are paid on the basis of hours worked and quantities
produced. The hours worked are recorded on clock cards and the
quantities produced are confirmed by the foreman. Wages are paid in
cash each Friday for the previous weeks work. Appointment of
employees is authorized by the managing director and the personnel
department maintains employees records and their rates of pay. The
cashier is separate from the wages department.
Previous years audits have highlighted weaknesses in internal controls in
the companys wages system. This has allowed an employee in the
wages department to perpetrate a fraud by creating fictitious employees
on the payroll and misappropriating the wages. Thus, some of your audit
test have been designed to detect whether this fraud is still taking place.
A starters and leavers test is carried out to ensure that employees are not
paid before they commence employment or after they have left.
Required:
(a)
(b)
Assuming you decide not to attend the wages pay out, suggest other
techniques you can use to check the existence of employees.
(c)
(d)
Describe how you will carry out a starters and leavers test.
Describe the analytical review techniques you can use in auditing
the wages system. This should include suggesting any ratios you
would calculate.
QUESTION THREE
You are a partner in an established practice . Mr Brown, a director of
Brown Keer Ltd approached you to investigate a suspected computer
fraud in his company. The company supplies civil engineering services to
the public and private sector. Most of his work is done through
subcontractors and as many as 100 subcontractors may be working on
projects at any one time.
268
Questions - Mocks
269
Required:
a. State in point form the factors you must consider and the procedures
your firm must follow before accepting this assignment;
(6 marks)
b. Describe the internal control weaknesses and accounting problems
that can normally be expected in circumstances where a small
company grows rapidly.
(8 marks)
c. List the main controls, which could have assisted in the prevention or
timely detection of fraud such as that which took place in the
circumstances outlined above.
(9 marks)
(Total: 23 marks)
QUESTION FOUR
Two important communications between the auditors and the
management or board of directors of the client entity are commonly
referred to as letter of representations and the management report or letter
of weaknesses. Both communications are referred to in ISA210. Terms
of audit engagement. The letter of representation is additionally the
subject of ISA 580 management representations and the management
report is referred to in ISA 400 risk assessments and internal control.
Required:
a) Letter of representation
i.
ii.
iii.
b)
Management report
Questions - Mocks
270
(i)
QUESTION FIVE
Recently the central bank of Kenya issued a guideline to banks and nonbank financial institutions advising them to consider setting up Audit
Committees.
You are required to set out below: a) The purpose and objectives of an audit committee.
(5 marks)
b) Composition of audit committee
(2 marks)
c) Responsibilities of an audit committee
(6 marks)
d) The relationship between the audit committee and the external
auditors (2 marks)
e) The relationship between the audit committee and the board of
directors
(2 marks)
(Total: 17 marks)
271
MOCK FOUR
QUESTION ONE
AMBER PAN EUROPE
You are an audit manager in Riebect & Co. a firm of Chartered Certified
Accountants. One of your audit clients, Amber Pan Europe (Amber) a
listed company with a 30 June accounting year end, provides wirefree
communications services in a rapidly growing market.
In August 2001 Amber purchased Talc, a competitor group of companies.
Significant revenue, cost and capital expenditure synergies are expected
as the operations of Amber and Talc are being combined into one group
of companies.
The following financial and operating information consolidates the
results of the enlarged Amber group:
Year end 30 June
2002
(Estimated)
2001
(Actual)
$m
$m
Revenue
7,585
4,893
Cost of sales
(3,454)
(2,212)
(1,889)
(24)
(1,030)
(735)
Finance cost
(296)
(224)
(407)
(191)
Contract (Note 1)
8,861
5,914
Prepaid (Note 2)
6,084
1,688
Contract
655
714
Prepaid
241
283
Average
(APRU)
revenue
per
user
272
Questions - Mocks
Notes:
1. Contract customers have specified minimum terms and monthly
subscription charges.
2. Prepaid customers have no monthly subscription charges and pay for
airtime through refill cards/vouchers
In may 2002 Amber purchased Socolla, a large mobile phone network
operator in East Africa, where your firm has no representation. The
financial statements of Socolla for the year ended 30 June 2002 will
continue to be audited by a local firm of Chartered Certified Accountants.
Socollas activities have not been reflected in the above estimated results
of the group. Amber is committed to introducing its corporate image into
Africa.
In order to sustain growth, significant costs are expected to be incurred as
operations are expanded, networks upgraded and new products and
services introduced.
Required:
a) Identify and describe the principal business risks for the Amber group
(8 marks)
b) Explain what effect the acquisitions will have on the planning of
Riebecks audit of the consolidated financial statements of Amber for
the year ending 30 June 2002
(10 marks)
c)
QUESTION TWO
Aspersion
You are the manager responsible for the audit of Aspersion, a limited
liability company, which mainly provides national cargo services with a
273
small fleet of aircraft. The draft accounts for the year ended 30
September 2001 show profit before taxation of Kshs27 million (2000
Kshs22 million) and total assets of Kshs104 million (2000 Kshs98
million). The following issues are outstanding and have been left for
your attention:
(1) The sale of a cargo carrier to Abra, a private limited company, during
the year resulted in a loss on disposal of Kshs400,000. The aircraft
cost Kshs12 million when it was purchased in October 1992 and was
being depreciated on a straight-line basis over 20 years. The minutes
of the board meeting at which the sale was approved record that
Aspersions finance director, Iain Jolteon, has a 30% equity interest in
Abra.
(7 marks)
(2) As well as cargo carriers, Aspersion owns two light aircraft which
were purchased in 1998 to provide business passenger flights to a
small island under a three year service contract. It is now known that
the contract will not be renewed when it expires at the end of March
2002. The aircraft, which cost Kshs450,000 each, are being depreciated
over fifteen years.
(7 marks)
(3) Deferred tax amounting to Kshs570,000 as at 30 September 2001 has
been calculated relating to tangible non-current assets at a tax rate of
30% using the full provision method (IAS 12 Income Taxes). On 1
December 2001, the government announced an increase in the
corporate income tax rate to 34%. The directors are proposing to
adjust the draft accounts for the further liability arising.
(6 marks)
Required:
For each of the above points:
(i) Comment on the matters that you should consider; and
(ii)
NOTE: The mark allocation is shown against each of the three issues.
QUESTION THREE
274
Questions - Mocks
You are the auditor of Beeys Ltd., a manufacturing company whose raw
material and other requirements are provided mainly by domestic
suppliers.
For the year ended 31 December 1994, you relied for audit purposes,
primarily on an appropriate division of duties and sound basic internal
controls over the manual systems for the recording of purchases and for
the payment of creditors by cheque.
With effect from 1 January 1995 the company opened a separate bank
account at the AD Bank Ltd. for the settlement of creditors accounts.
Since that date the company has been linked with AD banks mainframe
computer by means of a dial up link to microcomputer at the head office
of Beeys Ltd. Beeys Ltd., now uses the dial up link to access an
electronic funds transfer facility in order to pay its suppliers.
You have been informed that Jooste Stores Ltd., a retail chain, which is a
major customer of Beeys ltd., has announced its intention of encouraging
Beeys ltd. to join an Electronic Data Interchange (EDI) network. The
EDI network will enable Jooste Stores Limited to submit orders to Beeys
Ltd. electronically and that Beeys Ltd. will be able to invoice Jooste
Stores Ltd. via the EDI network.
You are planning the audit of Beeys Ltd. for the year ending 31
December 1995.
Required:
List in connection with your audit:
(a) The programmed access controls you would expect to have been
incorporated into the electronic funds transfer system used by Beeys
Ltd.
(9 marks)
(b) The additional measures that Beeys Ltd. should take in order to
prevent unauthorized transfers.
(8 marks)
(c) Outline briefly the most important risk to which Beeys Ltd. would
expose itself by joining EDN Network.
(8 marks)
(Total: 25 marks)
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QUESTION FOUR
You are responsible for the completion of the fieldwork of the audit of
Macho Ltd., a private company manufacturing domestic and industrial
cleaning appliances. The draft accounts have been presented to you as
follows:
Macho Ltd. Balance Sheet as at 30 November 1993
1993
Sh.
000
1993
Sh.
000
11,050
1992
Sh.
000
Fixed assets
3,250
Current assets
Stock and work in progress
6,695
Debtors
15,860
Cash at bank
4,745
27,300
Creditors: amounts
Falling due within one year
25,415
Net current assets
1,885
Total assets less current liabilities
6,045
Capital and reserves
Called up share capital
650
Profit and loss account
5,395
1992
Sh.
000
5,980
15,015
6,435
27,300
24,635
2,795
12,935
650
12,285
12,935
6,045
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Questions - Mocks
277
Write a file note for the partner in charge of the audit which:
(a) Briefly discusses the issues raised by these findings
(15 marks)
(b) Summarizes their financial impact on the draft accounts
(6 marks)
(c) States the action you would require before you would recommend
the issues of an unqualified audit report.
(3 marks)
NOTE: Ignore taxation
(Total: 24 marks)
QUESTION FIVE
Audit Failures
There is no doubt that the auditing profession is damaged when auditors
give a stamp of approval to the financial statements of a well known
company which subsequently collapses.
Required:
Discuss the ways in which the auditing profession could respond to the
issues raised by possible audit failures.
.
(Total: 20 marks)
278
Questions - Mocks
MOCK FIVE
QUESTION ONE
Computer Maintenance Services Ltd. are computer Engineers with a
current annual turnover of Sh.8,000,000. Generally customers are
invoiced for maintenance work at the time that service is provided
although the company offer their customers a three year service contract
on payment of a non-refundable fixed sum at the beginning of the contract.
You have been appointed auditor, your predecessors having resigned after
completing the audit for the year ended 30 September 1989. Their report
was unqualified.
You have commenced planning the audit of the financial statements for the
year ending 30 September 1990 and have found that on the basis that
payments for three year service contracts are non-refundable, the directors
have in previous years taken credit for all such income at the time that the
contract is entered into.
The management accounts for the year to date show that direct costs
represent approximately 80% of the service contract income. The net
profit for the year ended 30 September 1989 was Sh.480,000 and income
from service contracts entered into during that year amounted to
Sh.2,150,000.
You are required to write a formal letter to the directors setting out:
(a) Your reservations, if any, on the accounting policy adopted for three
year service contracts, and
(b) Your recommended treatment of such income, together with the
disclosures you consider necessary in order for the financial statements
to show a true and fair view.
(Total: 16 Marks)
QUESTION TWO
Azure sells inclusive tours (i.e. international flights, hotel accommodation
and meals) to two million customers. All hotels are independently owned
and operated. The company employs 5,000 people and uses 11 leased
aircraft. Azure has a representative office at each of 13 holiday locations.
279
Your firm has been invited to tender for the audit of Azure for the year
ending 31 December 2002. As the prospective audit engagement manager,
you have been asked to identify the principal audit risks and other planning
issues, including audit strategy, to be presented as part of your firms
written submission. The invitation to tender indicates that written
submissions will be used as a means of short listing for the presentation for
the presentation stage.
You have obtained the following information from Azures Annual Report
2000:
a.
b.
3)
Turnover (Note i)
Operating profit before tax
Tangible non-current assets
Trade receivables
Cash and cash equivalents
Current liabilities (Note ii)
5% Convertible debt due 2005
(Note iii)
2000
942.8
27.3
109.1
29.7
138.6
(237.
2)
(73.0)
1999
763.7
25.7
80.3
18.2
91.0
(200.5)
-
Notes:
a.
Questions - Mocks
280
2000
4.3
16.7
1999
2.5
17.9
17.4
38.4
12.7
33.1
Required:
a) Explain the audit planning issues which should be included in the
written submission as requested by Azure
(15 marks)
b) Suggest and comment on appropriate selection criteria which should
be used by Azure in its evaluation of submissions received.
(10 marks)
(Total: 25 marks)
QUESTION THREE
You are the auditor of Progressive Investments Limited, a company
operating a chain of twelve stores in the country with a total turnover in
the region of Sh.150 million per annum and employing approximately 120
staff. The Finance Director has informed you that the company is to set up
an internal audit department responsible to him with a staff of three. They
are to be responsible for reviewing and recommending improvements to
the systems of internal control. In addition the finance director has
suggested that in order to improve existing systems of internal control the
internal audit department would be required to authorise all payments over
a specified limit, the payment of salaries to all staff and the issue of credit
notes.
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Answers- Mocks
ANSWERS MOCKS
MOCK ONE
QUESTION ONE
HYDRASPORTS
(a) (i) Business risks (ii) Financial statement risk
Tutorial note: As part (ii) is clearly related in the requirement to part (i),
it is appropriate that a tabular approach be
adopted.
The standard design of facilities increases operational` risk as any
difficulties encountered in one facility will be compounded by the
number of other facilities (potentially all) which are similarly affected.
This is illustrated by the closure of the saunas.
Tutorial note: Standard design may also reduce risk as it results in a
higher quality product.
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Answers- Mocks
Permanent loss of customers requiring childcare facilities increases
operating risk. Compliance risk is increased if the new guidelines
are not met.
Similarly, inability to retain lifeguards increases operational risk
that pools cannot open (due to health and safety regulations).
Compliance risk is increased by the possibility that pools may be
operated without a lifeguard being on duty.
Disclosure risk is (again) increased if fines/penalties arising are
material and not disclosed.
High staff turnover indicates increased operational risk (poor
human resource management, inefficiency in working practices,
reduced capacity, etc).
Staff costs may be overstated as the risk that payments may be
made to leavers is increased.
Limitations on centre managers levels of authority may not be
commensurate with their responsibilities. Empowerment risk
arises if managers are not properly led (and if they, in turn, do not
properly lead their centre staff).
Any lack of integrity may increase the risk of management and/or
employee fraud, illegal acts and unauthorised use of company
assets. In particular the assertion of existence of assets may be at
risk (resulting in overstatement).
More centres may become loss-making if the reasons for falling
membership are not addressed.
Loss-making centres should be tested for impairment as cashgenerating units.
The hydrotherapy pool cannot operate until construction is
completed and completion may be threatened by cash flow
difficulties.
The value of the asset in construction should be written down if it
is impaired (even though it has not yet been brought into use).
Cash flow difficulties increase liquidity/financial risk. See above
reference to going concern and disclosure risk.
Obsolete gym equipment increases operational risk as customer
satisfaction decreases and health and safety risks are increased.
Depreciation may be overstated if Hydrasports continues to
calculate depreciation on fully-depreciated assets.
Disclosures for capital commitments (e.g. to replace equipment) in
the financial statements may be inappropriate if Hydrasports does
not have funds to finance such commitments.
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Answers- Mocks
Borrowing costs associated with this substantial (heavy) investment
should be agreed to finance terms and payments. The calculation of
any amount capitalised should be recomputed to confirm accuracy.
The basis of capitalisation, if any, should be agreed to comply with
IAS 23 Borrowing Costs (e.g. interest accruing during any
suspension of building work should not be capitalised).
As the construction has already cost twice as much as budgeted, its
value in use (when brought into use) may be less than cost.
Managements assessment of possible impairment (of the
hydrotherapy pool and the centre) should be critically appraised.
Tutorial note: The asset should not yet be subject to depreciation as it has
still to be brought into use.
(c) Performance indicators social/environmental responsibility
Member satisfaction
Number of people on membership waiting lists (if any).
Number of referrals/recommendations to club membership by
existing members.
Proportion of renewed memberships.
Actual members: 100% capacity membership (sub-analysed
between peak and off-peak).
Membership dissatisfaction
Proportion of members requesting refunds per month/quarter.
Proportion of memberships lapsing (i.e. not renewed).
Staff
Average number of staff employed per month.
Number of starters/leavers per month.
Staff turnover/average duration of employment.
Number of training courses for lifeguards per annum.
Average hourly (weekly) wage: average national hourly (weekly)
wage (or national minimum).
Predictability
Number of late openings (say more than 5, 15 and 30 minutes after
advertised opening times).
Number of days closure per month/year of each facility (i.e. pool,
crche, sauna, gym) and centre.
Safety
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Answers- Mocks
Safety drill reports (e.g. alarm tests, pool evacuations).
Accident report register showing date, nature of incident, personal
injury sustained (if any), action taken (e.g. emergency services called
in).
Any penalties/fines imposed by the local authorities and the reasons
for them.
Copies of reports of local authority investigations.
The frequency and nature of insurance claims (e.g. to settle claims of
injury to members and/or staff).
QUESTION TWO
Taurus Traders
(a) Principal Business Risks
Growth
The proposed expansion and diversification increase business risk, in
particular:
Builders merchants may prove unsatisfactory (e.g. DIY (Do It
Yourself) superstores may provide a more suitable outlet).
The overseas operation increase foreign currency exchange
transactions risk
Overtrading is already contributing to a cash flow crisis
Product quality is deteriorating perhaps through cheaper supplies
being sought
New loan fianc will increase gearing risk
Investment is needed in management/accounting personnel and IT
systems (see below)
Cash flow
Cash flows are not being adequately managed to meet the companys
obligations and liquidity risk is high.
The current cash flow crisis may have serious implications and
repercussions, for example,
Penalties and interest may be accruing on payment arrears
Suppliers may withdraw their credit facilities
289
The bank may refuse further finance including the Shs.2m loan
Penalties may be incurred if the building work does not go ahead
as contracted for
Poor debt collection procedures (e.g. large receipt not due for at
least another month) increase the risk of bad debts
Rolling over bills of exchange on overseas purchases may incur
supplementary interest premiums.
Faulty materials
Faulty materials indicate increased business risk because:
A reduction in quality may be underlying cause
Customer goodwill may be lost
A substantial accrual may be required for post year end credit
notes, in respect of returns
Materials returned to inventory may have net realizable value less
then cost and therefore require wiring down
Contingent liabilities may arise if faulty materials, being
specialist result in faulty building works/constructions
Subsequent cash sale may facilitate irregularities (i.e.
misappropriation of cash receipts).
Chief executive
The company operates under the dominant influence of Mr. Aquila,
who is also the majority shareholder. As a result:
He is in a position to abuse his authority (e.g. committing the
company to the building contract without consultation)
The organization structure is inadequate (especially when Mr.
Aquila is absent)
Errors may be made by the accountant (he may not have the
resources and training to fulfill the tasks assigned to him).
Errors arising may go undetected (because supervision is
inadequate)
The company is exposed to management bias.
The risk of management bias is particularly high because:
Mr. Aquila is in a position to influence financial reporting
Shs. 2m loan finance is being sought
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Answers- Mocks
There is a desire to meet profit forecasts
Shs. 52,000 loan account is to be repaid
Mr. Aquilas remuneration package may be dependent on
results
Financial information/Information technology
The annual budget and management accounts are not sufficiently
accurate to provide information for decision-making purposes. The
discrepancies on the control accounts could indicate that proper
accounting records have not been kept. Errors may also arise in the
computerized system. It is possible that the bespoke software is not
adequate for Taurus needs (e.g. if the choice of software writer was
based on the family relationship rather than his technical competence
or relevant experience). The financial and accounting systems which
is required to produce a profit forecast for the bank and financial
statements for audit, may be deficient.
IT currently employed does not adequately support current needs
(foreign currency purchase) and will require upgrading to meet future
needs (recording transactions of overseas operations).
Going concern
There are doubts about the companys ability to continue as a going
concern because it is dependent on:
Mr. Aquilas personal involvement in the negotiations of
transactions
Increased overdraft facilities
New, Shs. 2m, loan finance
Resolution of the faulty material problem
Debt collection being improved
Relevant, reliable and accurate information being available to Mr.
Aquila for decision-making purposes.
(b) Factors affecting decision to accept engagement
Tutorial note
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Answers- Mocks
Justification
High inherent and control risks (see below) render detection risk low.
Because of the lack of prior knowledge, analytical procedures may have
limited application (and non-sampling risk may exist).
As error incidence may be high, large samples must be planned to keep
sampling risk low. In particular, the intolerance of monetary unit
sampling to errors may necessitate more sophisticated, computerassisted, methods being adopted.
Inherent risk
In addition to the business risks there are also the risks arising from our
lack of prior knowledge. Although a lot of information will have been
obtained in connection with the proposal we will, for example, have
little knowledge of error incidence in the accounting systems.
Control risk
Control risk in all accounting areas is high because:
The chief executive has sole, overall control
There is a lack of segregation of duties
Accounting personnel are insufficiently qualified
Computer software may be inadequately maintained
Important accounting controls e.g. control account reconciliation, are
absent.
Revenue/receivables
There is a risk of overstated because, for example:
Management requires high profits
The receivables ledger control account is not reconciled
Credit notes for faulty materials may not be accrued
Provisions for bad and doubtful debts may be inadequate
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Answers- Mocks
Formal budgets setting procedure and the preparation of monthly
management accounts should be established for forecasting and
variance analysis. To cope with the uncertainty, which will
surround continued growth and expansion a system of rolling
budget might be appropriate.
Control account reconciliations
The reasons for differences on the receivables and payables control
accounts should be identifies and resolved. (For example, it is possible
that the differences on the payables control account are related to foreign
exchange translation calculations). The control accounts must then be
reconciled monthly. This will be a pre-requisite to improving cash flows.
Debt collection
Credit control must be improved to ease the cash flow crisis and reduce
the need to provide for bad and doubtful debts. Specialists assistance in
the form of debt factoring may be advisable. Incentive discounts could
be introduced also.
Settlement of accounts payable
Credit terms should be negotiated with suppliers and adhered to. It may
be advantageous to accept prompt payment discounts through this may
require pre-negotiations of the bank overdraft facility.
QUESTION THREE
TUTORIAL NOTES:
Service calls when a customer machine starts to bring problems like
producing bad copies the customer will contact the service department of
Image Ltd. The receptionist at the service department will take down the
customer details, mode of the machine ascertaining from him whether or
not its billable or rental and a brief description of what would appear to
be the problem with the machine.
The details would then be recorded in a register or a form e.g a request
for service form. The receptionist will pass on the details to the head of
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Answers- Mocks
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Answers- Mocks
3.
4.
5.
6.
number of unit prepared are present and are of the right length
as transactions cannot be properly processed if necessary data
is missing.
(b) A valid character check to ensure that the data fields appears to
be of the right type e.g. the date of service should be all
numeric, the materials used should be mixed, time taken
should be all numeric. This is to ensure data fields appear to
be correct.
The details regarding the customer should be consistent i.e. the
customers name is given, then the account number given must be
of that customer in the customers master file and the serial
number on the docket must be the serial number that belongs to
that customer.
As a combination of errors can occur regarding these details e.g.
wrong serial number or account number, I would expect the
program to execute a master file check of the customer details as
per the dockets to the customers master file.
The details regarding the parts used include the code number for
the par, a verbal description of the [art and the quantity used on
the job. It is possible that the technician can make errors in filling
in the data fields. Therefore I would expect the program to:
(a) Execute a master file check against the service parts master
file to ensure that the code number given and the description
given are for a part on that master file and that the quantity
was the quantity released for that machine.
(b) Execute a master file check against the returned used parts
master file to detect whether the technician had returned a
similar part after providing the service.
(c) Execute a check digit to the code number and matching the
code number to the description to detect keystroke errors in
the code number and the description.
The technician could indicate more or less hours than actually
spent at the customers premises. Consequently a customer may
be overcharged or undercharged. Therefore I would expect the
program to execute a limit or reasonableness check against the
standard established for the different possible combination of
services as per the service rendered price master file.
The service engineer manually checks the dockets details against
the rental contract master file print out. As a result of this he
indicates on the docket whether the machine is billable or rental.
He could wrongly indicate a billable machine as a rental machine
and vice versa. Therefore I expect the program to execute a
299
master file check at the serial number on the docket against the
computerized rental controls master files ensuring that if the serial
number given is not on that rental contract master file then
automatically this would be a billable machine.
7. Dockets may not be raised for some job cards a job cards may
be used to prepare more than one docket. I would expect the
program to execute the following steps:
(a) Undertake a sequence checks on the job card numbers to
detect incidences of duplication of job card m numbers and
to report gaps in numerical continuity of job card numbers.
(b) To execute a matching routine matching job cards to
dockets ensuring for every job card there is a docket and
vice versa.
8. I would expect the program to execute a reasonable test on the
job service against date on job card to ensure the dates are the
same and the transactions will be reported in the correct
accounting period when it took place.
9. I would expect to execute a reasonableness check on the data of
service on the docket and the date the materials were released
as per the stocks master file and print pout an exception where
the party details have not been reflected on a docket and
particularly if they are long outstanding.
(b) Principles of system development stipulate that when changes
are applied to systems similar requirements would apply as new
systems. Therefore if new consideration is given to review,
testing and approval of new systems it should be noted that the
basic principles of the controls are that:
(i)
Systems design should include representatives of
computer department, user
Departments and internal audit as well as the accounting
department.
(ii)
The proposed system would have written
specifications that are approved by both the management
and users.
(iii)
A systems testing should involve both users and the
computer department.
(iv)
The computer manager user department database
administrator where appropriate and the appropriate levels
of senior management should give final approval to the view
system before it is placed in operation and after reviewing
the appropriateness and the results of testing.
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Answers- Mocks
The appropriate procedures and policies for the review testing and
approval of new systems are best analyzed or considered under the
stages of systems development. The stages of system development
are normally classified as:
(a) Feasibility study
(b) Systems analysis and design
(c) Programming
(d) Programme testing
(e) Parallel running
(f) File conversion and implementation
(g) Monitoring and evaluation
QUESTION FOUR
CAPRI GROUP
(a)
Support letters
Tutorial note: Although there are different types and uses of such
letters (e.g. for registering a prospectus), the only reference to
them in the p3.1 Syllabus & Study Guide is in the context of group
audits.
Consolidated financial statements are prepared on a going concern
basis when a group, as a single entity, is considered to be a going
concern. However, the going concern basis may only be
appropriate for certain separate legal entities (e.g. subsidiaries)
because the parent undertaking (or perhaps a fellow subsidiary) is
able and willing to provide support. Many banks routinely require
a letter of reassurance from a parent company stating that it would
stand behind a subsidiary if the subsidiary were to have problems.
As audit evidence:
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Matters to be considered
Tutorial note: In broad terms these include the assessments of
materiality, what the draft auditors report and note disclosures
mean, the implications for the consolidated financial statements of
the Capri Group and Moltisants auditors report thereon.
Materiality
Capri (Overseas) constitutes 306% of Capri Groups profit
before taxation and 20% of the Groups total assets (2001
309% and 221% respectively) and is therefore material to the
consolidated financial statements. These percentages would be
greater if payments in respect of finance leases were not all
expensed and the related assets were recognised in the balance
sheet of Capri (Overseas).
The fair value of assets excluded from the balance sheet
represents 122% of the total assets of Capri (Overseas) and is
therefore material to this subsidiarys financial statements.
Kshs.790,000 represents 24% of the total assets of the Capri
Group and is therefore material also to the consolidated
financial statements.
Draft auditors report
The meaning of the basis of opinion paragraph (extract) is
unclear in the following respects:
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Answers- Mocks
there is no reference to non-compliance with relevant IASs
(IAS 17 Leases and IAS 12 Income Taxes);
- what is in accordance with local taxation regulations the
treatment of the finance lease payments and/or the nonprovision of deferred taxation;
- Marcel does not expressly state whether or not they concur
with the treatments.
That the opinion paragraph is unqualified implies that Marcel
concurs with the accounting treatments. (As the matter is
material, at least in relation to the finance leases, Marcel would
have to qualify their opinion if they disagreed with it.)
If Marcel concurs, then the references to the notes (4 and 5)
amount to an emphasis of matter. As such it should be presented
after the opinion paragraph to make it quite clear that the
audit opinion is not qualified in this respect.
Whether Marcels prior year auditors report was similarly
modified.
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in the prior year, Marcels current year report should draw attention
to the fact that this was previously reported.
Implications for consolidated financial statements and Moltisants
auditors report thereon
As Capri (Overseas) is a subsidiary it is, by definition, controlled by
the Capri Group and the management of Capri (Overseas) can be told
to adjust the subsidiarys financial statements (at least for
consolidation purposes). In this case Marcels auditors report should
be redrafted as unmodified and Moltisants auditors report would
similarly be unmodified (in this respect).
Alternatively, an adjustment can be made on consolidation of the
Capri Groups consolidated financial statements.
Moltisants
auditors report would then be unmodified.
If no adjustment is made in either the subsidiarys or the consolidated
financial statements, Moltisants auditors report should be qualified
except for non-compliance with IASs 12 and 17. The effect of noncompliance with IAS 12 should be quantified.
The consolidated financial statements should not (usually) refer to
the financial statements of Capri (Overseas) being audited by another
auditor.
Tutorial note: In some jurisdictions a principal auditor is permitted to
base the audit opinion on the financial statements taken as a whole solely
upon the report of another auditor, in which case such disclosure should
be made and the magnitude of the portion of the financial statements
audited by the other auditor indicated.
QUESTION FIVE
The OECD (Organization for Economic Cooperation and Development)
and World Bank are actively involved in initiatives to promote corporate
governance practices (e.g. holding an annual forum on the subject). In
1999, the OECD issued a set of Corporate Governance principles which,
although non binding, reflect the concepts of:
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These principles are now being promoted as framework for dialogue and
consultation with emerging and transition economies with the aim of
improving corporate governance practices.
Further in June 2000 OECD issued governance guidelines for
multinationals that provide voluntary principles and standards for
responsible business consistent with applicable laws. The International
Forum on Accountancy Development (IFAD) is an initiative of IFAC and
the World Bank. Its vision is to achieve a rational framework of
reporting on the performance of economic entities, which serves the
objectives of issuers and users across the world. This vision calls for
inter alia, improving corporate governance practices using the OECD
principles of corporate governance as a point of reference.
Needs for IASs
The need for a uniform set of international accounting standards to
provide for the transparency and consistency of financial reporting is
evident in that IOSCO (the international organization of securities
commissions) endorsed 30 International Accounting Standards for cross
border listings.
Although these are not (yet) global standards, it is envisaged that IASs
will become the international (i.e. global) standards and will not require
reconciliation to US GAAP.
Needs for ISAs
The auditing profession plays a key role in both national and international
regulation and the development to transparent international standards on
auditing (ISAs) provides a high level of assurance on the reliability of
financial reporting.
ISAs and International Auditing Practice Statements (IAPSs) have been
formulated by IFAC through its international auditing practices
committee (IAPC). A significant number of IFAC members use the ISA
as a basis for developing their own national standard. IAPC is now
working with IOSCO for endorsement of ISAs.
Need for corporate governance standards
Corporate governance may be defined as the ethical corporate
behavior by directors or others charged with governance in the
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The use of Global Shares by global business enterprises increases the
need for corporate governance rules to be global. Global shares (i.e. the
same form of shares for listing in a home country and a non home
country) enable virtually seamless cross border trading. As their use
becomes more widespread, global stakeholders will need higher quality
global accounting, auditing and corporate governance standards.
Regulators are national, not international, so international consistency is
needed to avoid regulation arbitrage. Global standards are necessary
because national and international standards will not converge of their
own voliation. Local subsidiaries of international groups tend to be
content (e.g. on cost grounds) to comply with lower local standards (e.g.
accounting and auditing) and not adopt the higher standards of their
parents location.
Companies in some countries (e.g. in India) have been advised not to
globalize until there is a framework for good corporate governance. It is
therefore asserted that global standards are key to developing countries
prospects for substainbly mobilizing capital for economic growth.
Developing countries can further benefit by imitating the models and
systems of another rather than incurring the costs of developing their
own models.
There does not have to be a one size fits all approach to global standard
because there are universally recognized standards that can provide
benchmarks (e.g. responsibility, accountability, fairness and
transparency). If universal principles of transparency and objectivity (for
example) can support international accounting and auditing frameworks,
then a global corporate governance model can cater for different legal
structures and cultural identities.
OECDs voluntary code provides a point of reference for multinationals,
which are encouraged to:
Contribute to economic, social and environmental progress
Respect the human rights of those affected by their activities
Encourage local capacity building
Encourage human capital formation (e.g. by creating employment
opportunities and through training programs)
Refrain from seeking/accepting exemption from environmental, health
and safety, equal opportunities and labor legislation, etc
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Alternatively
Accounting standards have been implemented on a nation-by-nation basis
before the international acceptance by IOSCO of international accounting
standards. Auditing standards are following suit. The OECD principles
are very general and as the need for global corporate governance
standards is apparent, the initiatives to create them will continue to
emerge.
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MOCK TWO
QUESTION ONE
Abacus Leasing
It should be apparent to a prospective auditor that the audit of Abacus
Leasing ltd is a high-risk audit and therefore the quality control
procedures to be adopted before tendering for such an audit would
include:
i.
ii.
iii.
iv.
v.
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Answers- Mocks
iv. There may be an element of overtrading causing the company to be
over borrowed, highly geared and experiencing liquidity problems.
v. The bonus incentive for management may have caused high-risk sales
(leases) to have been made or the turnover figure may have been
falsified.
vi. The nature of the products, building equipment, can have high
associated risks. There is frequent theft of this type of equipment and
as the equipment is often abused in its use it may not last the length of
the lease making default more likely.
vii. The high proportion of assets in the form of debtors which appear to
be difficult to collect and the lack of a formal system of collection.
(c)
(i) The principal aim is to determine whether a lease fails to be treated as
a finance lease or as an operating lease. It may also be possible that
some agreements are not leases at all. If they contain an option of
purchase that is likely to be exercised they should be treated as hire
purchase agreements although such treatment is in substance similar
to a finance lease.
IAS 17 Leases says that a finance lease transfers substantially all
the risks and rewards of ownership to the lesser. This is deemed
to occur when the present value of the minimum lease payments
amounts to substantially all (normally taken as 90% or more) of
the fair value of the asset.
Therefore the auditor must perform the following work.
i.
ii.
iii.
iv.
v.
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(ii)The work the auditor would do to confirm the estimate of the bad
debts provision is:
1. Confirm the gross debtor by the tests above and, using an
appropriate sample, perform a positive debtors circularization.
2. The auditor should focus his attention on recent debtors, as these are
likely to be of greater value and at more risk of non-payment.
Leased debtors differ from normal trade debtors in that they are not
receivable within a short period of time. The auditor should check
to see if any debtors contain overdue installments. Such debtors are
more likely to be bad. Some of the lessees may be in dispute and
the payments have been stopped. This should be investigated by the
auditor.
3. The auditor should review the companys procedures for recovery
of debtors which have breached the terms of the agreements. As
these are known to be weak further substantive testing should be
performed to confirm the value of the debtor balances.
4. The above tests should give the auditor a basis for estimating the
gross provision required for bad debts. From the information in the
question this is likely to be a high figure due to the credit standing
of some of the debtors and the sales policy encouraged by the bonus
scheme.
Lease debtors again differ from most trade debtors in that
Abacus Leasing ltd retains ownership of the related assets.
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Where an agreement is in default such assets may be
repossessed by the company.
If Abacus Leasing ltd has reduced the gross provision by an estimate of
the recoverable amount of leased assets the auditor must do further
work. The auditor should try to obtain proof of the physical existence of
the assets to confirm they are still in the possession of the lessee and to
determine their condition. This may be very difficult in practice. The
auditor would then form an opinion of the recoverable amount of the
assets. This would either be an estimate of the their net selling price or
their fair value if leased to another builder. The value to be used would
be dependent upon the intention of management and the auditor
agreeing its appropriateness.
QUESTION TWO
Midland Builders
(a) IAS 10 (revised) Events after the Balance Sheet Date deals with
events which occur between the date of the balance sheet and the
date the accounts are drawn up. The events may need to be
incorporated in the financial statements. Those that do are called
adjusting events (they provide additional information on the
conditions existing at the balance sheet date) and those events which
do not affect the position at the date of the balance sheet nonadjusting events which may require to be referred to as note to the
financial statements (unless it affects the company as a going
concerning).
The directors view is therefore incorrect. If the events provide
additional information on the conditions existing at the year end then
an adjustment should be made.
(b) Several are possible from the following list
Identifying items at the balance sheet date which may be
susceptible to later confirmation.
Enquiring into managements procedures for dealing with post
balance sheet events.
Reviewing accounting records and cash flows
Reviewing clients internal management reports including budget
reports and interim accounts.
Reading minutes etc
Reading external documents which may have an impact.
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Obtain schedule (this is the sum to be audited)
Examine previous year schedule (for analytical review)
Carry out analytical review (compare with monthly purchases and
previous years ration for reasonableness, to identify situations
requiring further study)
Determine, record evaluate and test internal control system
(always necessary if any reliance is to be placed on internal
controls, for example for completeness evaluation)
Cut off testing (the major source of error, to be carried pit in
conjunction with other areas e.g. stocks and sales)
Control account agreement (clearly if this does not balance then
the creditors may not be correct)
Examination of individual balances (also to verify accuracy of
processing)
Examine suppliers statements (to check balances with external
evidence)
Possibly circularize creditors (to obtain true independent third
party evidence)
Examine post balance sheet events (to determine if all creditors
are included).
(b) Sundry accruals
Obtain schedule (this is to be audited)
Obtain schedule of previous year (for comparison)
Analytical review (to see if last years items have this year items
also and also to see that expected items are present.
Substantiate each item (to ensure correct amount is included)
Examine post balance sheet events (to ensure all items are
included)
(c) Provisions
Examine all provisions (are they needed?, is the amount too large
merely to reduce profits?, are they too little to avoid reducing
profit?
Examine directors minutes, post balance sheet events,
correspondence with lawyers etc for evidence of the need for
provisions (essential to ensure all necessary provisions are
included)
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Precision level
The reliability factor taken from tables is associated with the level of
assurance the auditors want or need to obtain from the test. The precision
level is the number of errors the auditors are willing to accept in a
population to be assured that the population is correct.
(iii)
(c)
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(d)
ii.
iii.
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QUESTION FIVE
(a) 1. The weakness in the cash system are as follows:
i. The physical location of the dispatch department and the cashier
are not mentioned here, but there is a risk of the customer taking
the goods without paying. The customer should pay the cashier on
the advice note and return for the goods, which should only be
released on sight of the paid invoice.
ii. There is a failure in segregation of duties in allowing the cashier to
both complete the sales invoice and receive the cash as he could
perpetrate a fraud by placing the original invoice with one of lower
value and keeping the difference.
iii. No one checks the invoices to make sure that the cashier has
completed them correctly, for example by using the correct prices
and performing calculations correctly.
iv. The completeness of the sequence of sales invoices cannot be
checked unless they are pre numbered sequentially and the
presence of all the invoices is checked by another person. The
advice notes should also be pre numbered sequentially.
v. There is also no check that the cashier banks all cash received, i.e.
this is a further failure of segregation of duties.
If the sales department prepared and posted the invoices and also posted
the cash for cash sales to a sundry sales account, this would solve some
of the internal controls problems mentioned above. In addition, the sales
department could run a weekly check on the account to look for invoices
for which no cash had been received. These could then be investigated.
All of these weaknesses and possible remedies should be reported
to management.
2. After confirming the cash sales system was operating as described (by
walk-through test) I would carry out the following tests in order to
ensure that there was no material fraud or error in the operation.
i. Select a sample of advice notes issued to customers during the
year. Trace the related sales invoice and check that the details
correlate (date, unit amounts etc). The customer should have
signed for the goods and this copy should be retained by the
dispatch department.
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ii.
For the sales invoices discovered in the above test, I would check that
the correct advice note number is recorded on the invoice, that the
prices used are correct (by reference to the prevailing price list)
and that the castings and cross-castings (i.e. arithmetic) is correct.
iii. I will then trace the value of the sales invoices to the cashbook and
from the cashbook that the total receipts for the day have been
banked and appear promptly on the bank statement.
iv. I would check that the sales invoices have been correctly posted to
a cash or sundry sales account. For any sales invoices missing
from this account (assuming they are sequentially numbered), I
will trace the cancelled invoice and check that the cancelled
invoice was initialed by the customer and replaced by the next
invoice in sequence.
v. Because of the weakness in the system I would carry out the
following sequence checks on large blocks of advice
notes/invoices, e.g. four blocks of 100 advice notes/invoices.
Check all advice notes present; investigate those missing
Check sales invoices raised for all advice notes
Check all sales invoices in a sequence have been used;
investigate any missing
Cash for each sales invoice has been entered into the cashbook.
Using the results of the above tests I would decide whether
the system for cash sales has operated without material
fraud or error. If I am not satisfied that it has then I will
consider qualifying my audit report on the grounds of
limitation of scope.
(b) (i)
The control is designed to ensure that all receipts are
banked in the companys
account.
This presence of two employees when mail is opened
makes it unlikely that there will be theft of receipts, as this
would require collusion between them. Compilation of a
list of receipts provides an agreed record, which can be
used as a check that receipts are not misappropriated
before they are banked.
Neither of these people should be the cashier as this too
would be a breakdown of internal control in terms of
segregation of duties.
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(ii) Audit tests on the opening of mail and the subsequent banking of
cheques might
include the following
i.
ii.
iii.
iv.
v.
vi.
(c) (i)
reasons.
ii.
iii.
iv.
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v.
Compensation is given to the customer, perhaps because goods
were faulty (but they were not returned) or goods were
delivered late, etc.
(ii)
I would carry out the following audit work to test whether
credit notes were
authorized and issued for a valid reason.
i.
ii.
iii.
iv.
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MOCK THREE
QUESTION ONE
Tutorial note: These model answers are considerably longer and more
detailed than would be expected from any candidate in the examination.
They should be used as a guide to the form, style and technical standard
(but not length) of answer that candidates should aim to achieve.
However, these answers may not include all valid points mentioned by a
candidate credit will be given to candidates mentioning such points.
1 MEADOW
(a) Principal audit risks and other matters
Tutorial notes:
(1) The requirement to identify and explain suggests that although
marks will be awarded for the mere identification of risks etc from the
scenario (e.g. loss on operations), those risks must be described (as
illustrated below).
(2) Other planning matters include materiality, audit approach/strategy
to balances and transactions, accounting
treatments, etc including practical/logistical issues.
Risks
Inherent risk is increased at the entity level as Meadow operates in
geographically diverse locations.
Apart from going concern risks, the reduction in consumer spending
may have implications for the valuation of inventory, particularly
home furnishings (luxury goods).
Meadows principal activity is identified with a single brand name.
Any damage to the reputation of the Vazandt name in one geographic
area (e.g. following the closure of African operations) may affect retail
trading elsewhere.
Inherent risk is increased at the account balance and class of
transactions level because, for example, advantage may be taken of
2002 appearing to have been a bad year and certain accounting
policies may be overly prudent (e.g. in providing for future trading
losses). Conversely, management may be biased to overstating
revenue/profit/asset values and understating other expenses and
liabilities to conceal the extent of a bad year.
Inventory may be overstated if net realisable value is less than the
carrying amount determined using the retail method if, for example:
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The substantive evidence to be obtained during the final audit is
likely to rely heavily on analytical procedures because, for
example, disaggregated information will be available by store,
business unit, geographic region, etc.
Analytical procedures are likely to be used extensively for
substantive purposes given:
- the uniform nature of operations across Meadows retail
activities;
- the multiple locations over which it operates;
- the clearly identified business units.
Also, the number of stores in each geographic area is only one
more or less than the prior year (facilitating comparison with prior
year ratios, etc).
In particular, in the retail industry, the relationship between gross
profit and sales revenue may be expected to remain constant
(within geographic regions and business units).
Given the high volume of low value transactions which make up
turnover in a retail business, assurance about the completeness of
recorded revenue may be obtained by applying known profit
margins (as used to apply the retail method of inventory valuation)
to independently verified cost of sales (i.e. purchases as adjusted
by the movement in year-end inventory).
Trend analysis (i.e. the comparison of current data with prior
periods) may be particularly useful for analysing income (e.g.
monthly revenue by store and business unit).
Documentation
The overall audit plan and audit program should be amended to reflect
changes in:
- materiality assessment;
- risk assessment (e.g. if inherent risk is higher because operational
losses were not expected or control risk is lower because greater
reliance can be placed on internal controls);
- draft financial statements as compared with prior year (see
below).
Logistics
The work of Robert Braccos affiliated offices will have been coordinated (e.g. to ensure that staff were available to visit selected
stores at the year end).
The results of store visits (e.g. to attend physical inventory counting
and count cash) should be summarised to identify any stores in
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However, the boards decision to restructure does not appear to give
rise to constructive obligation because Meadow has not (before the
balance sheet date):
- started to implement the restructuring plan; or
- raised a valid expectation in those affected that the restructuring
will occur (because the decision is dependent on further
consultation).
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(i) Segment information
Tutorial note: The principle is that when segment information is
material, sufficient appropriate audit evidence should be obtained
that its disclosure is in accordance with the identified financial
reporting framework (i.e. IAS 14 Segment Reporting).
Agree the geographical segments and the corresponding figures to
those reported in the prior year.
Check the arithmetic accuracy of the disclosure (i.e. cast the totals)
and agree the turnover and operating profit totals to the amounts
shown on the face of the income statement.
Agree the make up of segment revenue (less segment expense =
segment result) to internal (e.g. management accounting) analyses
(or consolidation schedules).
Test check the make up of the analyses, on a sample basis, to
confirm their accuracy.
Consider the appropriateness of the geographic segments identified
for the primary reporting format.
Similarly agree the secondary information that should be reported
for the business segments (Ladieswear, Menswear, Home
furnishings and Foods).
Review the basis on which expenses that arise at the enterprise level
(e.g. head office costs) on behalf of segments (if any) are attributed
to segments and confirm that it is reasonable (and in agreement
with prior year basis).
(ii) International restructuring
The detailed, formal plan for the discontinuance of the African
operations should be obtained and reviewed to confirm the part of
the business/principal locations affected. The detailed plan should
also provide evidence concerning:
the location, function, and approximate number of employees who
will be compensated for termination of their services;
the expenditures that will be undertaken; and
when the plan will be implemented.
The date of the board minute(s) approving the announcement of the
intention to close the African operations and sell the South
American operations should be noted.
Copies of the announcement(s) should be reviewed (e.g. press
statements).
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ii.
iii.
iv.
v.
vi.
vii.
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ii.
iii.
iv.
v.
(c) I will compile a list of starters and leavers between dates (perhaps
six months apart) from personnel records of staff starting and leaving
dates, checking that these records have been authorized by a
responsible official.
The payroll at each of these two dates can then be examined and it
will be possible to check that, for employees leaving between the two
dates, there is no pay shown at the later date and that for employees
joining there is no pay at the earlier date. (I will check, respectively,
the two weeks after and before the event). If the examination of the
payroll at the two dates revealed other apparent starters or leavers,
these instances would be investigated.
The payroll should be scrutinized around the date of
starting or leaving for a sample of starters and leavers in
order to ensure that pay starts or ceases at the appropriate
date. This test needs to take into account any special
procedures, which apply. For example, leavers may be
paid final holiday pay early, on the date they cease work
but prior to their date of officially ceasing employment.
Similarly, special arrangement might apply to the pay of
employees joining.
(d) Analytical procedures that can be used in auditing the wages
systems include the following.
i.
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ii.
Calculate average wage per employee and consider for reasonableness
(compared to the previous year). I will take account of pay rises
according to union negotiations etc.
iii. Compare the proportion of payroll expense allocated to different
departments, e.g. admin, distribution, to that of previous year.
Investigate any significant differences.
iv. Check that pension contributions are at the expected level for
gross pay, according to the companys scheme.
v. Calculate the ratio of wages to sales. Compare with prior years.
vi. Check the ratio of statutory deductions to gross wages. Consider
reasonableness given fixed PAYE/NSSF rates and also compare
with prior year
QUESTION THREE
a)
Factors to consider before accepting the assignment
When a professional accountant is approached by a prospective
client to accept an assignment and another professional accountant
is providing auditing services to that prospective client the factors
to consider are: a. Whether there may be reasons, professional or otherwise why
the assignment cannot be accepted.
b. Whether there are adequate resources in terms of manpower
and skill to perform the assignment
c. Whether the timing and other requirements of the client are
realistic
After considering the above factors the accountant then follows the
following procedures before accepting the appointment.
1. Holds a meeting with the directors of the company to establish
in detail the aims of the investigation, the scope of the
investigation, the degree of detail required, the degree of
secrecy required, the cost of assignment the timing
requirements, including the period to be investigated and the
employees to be investigated. These discussions are essential to
form the basis of the engagement letter, which should be
received before the work can begin.
The accountant must obtain precise written instructions.
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2. The accountant must observe professional etiquette or
courtesies by informing the auditor, Mr. Solo, of the fact that he
has been approached to accept an assignment to investigate
fraud in his client. In addition to observing usual courtesies,
this helps to obtain the cooperation of the auditors, as it may be
required at some point. The accountant ensures that he obtains
the permission of the prospective client to communicate with
the auditor.
a)
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2. Pre numbering engineering certificates, insisting on their being issued
in numerical sequence with the original copy faxed by the engineer
being subsequently submitted to head office for comparison with the
faxed one.
3. An independent person at head office should have been charged with
the responsibility of checking the faxed certificates to confirm the
signatures of the engineers, check for the reasonableness of the
amounts certified, check for the numerical sequence of the
certificates, then prepared the list of genuine claims for approval by
the directors before the preparation of the magnetic tape containing
the payments.
4. The bank should have been asked to provide a hard copy list of actual
payments effected. These should have been compared to those
approved to detect any other payments fraudently inserted.
5. Project cost analysis should have been prepared regularly with
comparative contract amounts and submitted to the engineer in charge
to examine and review and confirm that the costs were reasonable.
The directors should also have reviewed these analyses and sought
explanations for significant fluctuations of variances
6. The work of the computer operators should have been supervised and
then checked for completeness and accuracy by a senior officer
before the magnetic tape was release to the bank for paying.
7. An audit trail should have been maintained by ensuring that a
printout is produced of all processing done by a computer. A director
should then have checked them regularly to detect apparently
fictitious entries.
8. Unused important stationery, such as the engineers certificates
should have been kept under lock and key and if pre numbered their
use controlled by a register.
9. Use of the fax machine should have been controlled to ensure that
only valid authorized documents are transmitted.
QUESTION FOUR
(a)
Letter of representation
1)
Purpose
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2)
Reliability
Failure, by the auditors, to confirm such representations in writing
would constitute negligence. However, it is important that auditors
do not place reliance on representations where more reliable
evidence would be expected. The absence of corroboratory
evidence would, in itself, be suspicious and should lead to further
audit enquiry.
Moreover, written representations do not
necessarily constitute sufficient evidence. The auditor must
consider all available evidence and its reliability in forming an
opinion. For example, in a small business where significant audit
reliance must be placed on management representations, auditors
may occasionally form the view that, even with written
representation by management, there is insufficient evidence on
which to form an opinion.
3)
Matters included
Matters that may be included in the letter of representation include
representations that:
All books of account and supporting documentation, registers,
minutes of members and directors meetings, have been made
available;
All related parties have been identified
The entity is not in breach of any contractual or regulatory
requirements that could have a material effect on the financial
statements.
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The entity has title to all its assets and none are pledged or
otherwise assigned other than disclosed in the financial
statements.
All liabilities and provisions have been reported or disclosed in
the financial statements.
All subsequent events have been properly reflected or disclosed
in the financial statements.
There are no plans that may significantly alter the carrying
value of any of the entitys assets.
Note: Only three are required. Other matters may also be
considered relevant.
4)
Refusal
If management refuse to provide written representation as
requested, the reasons would need to be enquired into the effect on
the overall sufficiency of evidence considered. Generally, if a
matter is sufficiently important as to warrant a request for its
inclusion in the letter, a failure to obtain written representation
would normally constitute a scope limitation resulting in the issue
of a modified audit opinion which is either qualified or which a
disclaimer of opinion is issued.
(b)
Management report.
Procedures
Timeliness
Communication of control weaknesses is normally made shortly
after completion of the audit. On larger engagements where
controls risk was assessed during an interim visit, a letter should
normally be sent after that visit as well as on completion of the
audit.
Occasionally the matter may be sufficiently serious as to warrant
more timely communication, such as where the exposure to risk is
great or where there is reason to suspect that fraud or failure to
comply with laws or regulations may already have occurred as a
result of the weakness.
Method
As is implied in the title commonly given, the communication is
normally made in the form of a letter. Often, however, a
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The auditors duty to report on the effectiveness of internal controls,
under auditing standards is confined to the management of the entity.
They have no responsibility to report to other parties. The letter of
weakness normally carries a disclaimer of responsibility to any other
person to whom the letter might be shown.
Auditors may accept engagements to report on control weaknesses,
either to managers, to regulators or to third parties. However, such
engagements are not part of the audit of the financial statements.
QUESTION FIVE
a) The main objectives usually associated with audit committees
include;
i. Increasing public confidence in the creditability and objectivity of
published financial information including unaudited interim
statements
ii. Assisting directors (particularly non executive directors) in
meeting their responsibilities in respect of financial reporting
iii. Strengthening the independent position of a companys external
auditor by providing an additional channel of communication.
b.
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MOCK FOUR
QUESTION ONE
Tutorial note: These model answers are considerably longer and more
detailed than would be expected from any candidate in the examination.
They should be used as a guide to the form, style and technical standard
(but not length) of answer which candidates should aim to achieve.
However, these answers may not include all valid points mentioned by a
candidate credit will be given to candidates mentioning such points.
1 Amber Pan Europe
(a) Principal business risks
Tutorial note: The requirement to identify and describe suggests that
although marks will be awarded for the mere identification of risks
from the scenario (e.g. communications industry), those risks must
be described (as illustrated below).
Communications industry
Rapid and new technological developments in the industry, providing
faster data transmission and increasingly interactive capabilities, will
render certain existing products and services obsolete.
Amber cannot predict how emerging and future technologies (e.g.
cordless technologies such as Bluetooth) will affect demand for its
services.
Competition
Although Amber may have reduced competition in the short-term (by
having acquired a competitor), the communications market is still
expanding. Increasing competition from other existing and new
competitors offering new technologies could:
- affect Ambers ability to attract and retain customers
- reduce Ambers share of new customers
- force Amber to reduce prices.
The cost (and revenue-generating capabilities) of new technologies
tends to fall significantly and relatively quickly (e.g. mobile phone
technology is now available in disposable form).
Integration
Combining two groups which have previously operated independently
(and competitively against each other) is likely to result in disruption.
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Operations have been expanded from European countries to East
Africa. Ambers inexperience of economic and legal developments in
East Africa may impair the investment in Socolla.
Foreign exchange rates
Amber transacts business in several countries and foreign exchange
rate fluctuations could have a material adverse effect on operating
results.
Highly regulated market
Network operations could be adversely affected by changes in the
laws, regulations or government policies which regulate the industry.
Difficulties in obtaining approvals for the erection and operation of
transmitters could have an adverse effect on the extent, quality and
capacity of Ambers network coverage.
Allegations of health risks (e.g. associated with radio waves from
transmitter masts and mobile handsets) could reduce customer
demand and increase exposure to potential litigation.
Tutorial note: Candidates are not expected to have knowledge of
industry-related complexities (e.g. of licensing, subsidies and network
recharging) however, appropriate marks would be awarded for
comments on such business risks arising.
(b) Impact of acquisition on planning
Group structure
The new group structure must be ascertained to identify the entities
which will be consolidated into the group financial statements of
Amber for the year ending 30 June 2002.
Materiality assessment
Preliminary materiality will be much higher, in monetary terms, than
in the prior year. For example, if a % of turnover is a determinant of
preliminary materiality, it will increase by 55% (based on estimate).
Tutorial note: Profit is not a suitable criterion as group is loss-making.
The materiality of each subsidiary should be assessed, in terms of the
enlarged group as at the planning stage. For example, any subsidiary
contributing more than 10% of the groups assets and turnover (but
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not result!) is material and less than 5% (say) is not. This will identify,
for example:
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balances are not identified/reconciled. In particular, exchange
differences are to be expected.)
On analytical procedures
Having brought in the operations of a group of companies (Talc) with
similar activities may extend the scope of analytical procedures
available. This could have the effect of increasing audit efficiency.
Socolla on Income Statement
The effective date of the acquisition of Socolla may be so late in the
financial year (only 48 weeks, say, before the year end) that it is
possible that its post-acquisition results are not material to the
consolidated income statement.
Other auditors
Other auditors will include:
- any affiliates of Riebeck in any of the countries in which Amber
(as combined with Talc) operates; and
- the unrelated auditors (of Socolla).
Riebeck will plan to use the work of Socollas auditors who are
Chartered Certified Accountants. Their competence and independence
should be assessed (e.g. through information obtained from a
questionnaire and evidence of their work).
A letter of introduction should be sent to the unrelated auditors, with
Ambers permission, as soon as possible (if not already done)
requesting their co-operation in providing specified information
within a given timescale.
Group instructions will need to be sent to affiliated and unrelated
auditors containing:
- proforma statements
- a list of group and associated companies
- a statement of group accounting policies (see below)
- the timetable for the preparation of the group accounts (see
below)
- a request for copies of management letters
- an audit work summary questionnaire or checklist
- contact details (of senior members of Riebecks audit team).
Accounting policies (Talc & Socolla)
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Whilst it is likely that Talc has the same accounting policies as Amber
(because, as a competitor, it operates in the same jurisdictions) Socolla
may have material accounting policies which do not comply with the
rest of the group. Riebeck may request that Socollas auditors
calculate the effect of any non-compliance with a group accounting
policy for adjustment on consolidation.
Timetable
The timetable for the preparation of Ambers consolidated financial
statements should be agreed with management as soon as possible.
Key dates should be planned for:
- agreement of inter-company balances and transactions
- submission of proforma statements to Riebeck
- completion of the consolidation package
- tax review of group accounts
- completion of audit fieldwork by other auditors
- subsequent events review
- final clearance on accounts of subsidiaries
- Riebecks final clearance of consolidated financial statements.
Tutorial note: The order of dates is illustrative rather than prescriptive.
(c) Use of analytical procedures
Tutorial note: Candidates will be expected to know f that analytical
procedures must be used at the planning and review stages and may be
used as substantive procedures. For good marks candidates at this level
will be expected to apply such knowledge using the financial and
operating information given in the scenario.
At the planning stage
Analytical procedures must be used at this stage (sometimes called
preliminary analytical review). Riebecks knowledge and
understanding of Ambers business will be assisted by the
accumulation of information. For example:
- The 55% increase in turnover should be commensurate with the
purchase of the Talc group.
- There is a downward trend in the key performance indicator
(ARPU has decreased by 82% for contract customers and 148%
for prepaid customers).
- The number of contract customers has increased by 498%, the
number of prepaid customers by 260%. This should reflect the
acquisition of Talcs customer base, market expansion and perhaps
shift in customer preference from contract to prepay.
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Analytical procedures can also be used to identify areas of potential
business and audit risk. For example:
- Although the 56% increase in cost of sales is in line with turnover,
distribution and administrative costs have increased by nearly 70%
if Amber is not realising the cost benefits it expected through
synergy, this is a business risk (see (a)).
- Expenditure on R&D looks very low (036% of 2002 turnover
049% for prior year). This could indicate a business risk e.g.
Amber is not making sufficient investment in R&D (necessary in
this industry). It could also indicate an audit risk that Amber is
capitalising development costs which do not meet the recognition
criteria for an intangible asset
(IAS 38 Intangible Assets).
Riebeck can use analytical procedures to assist in determining the
nature, timing and extent of other audit procedures (i.e. audit
strategy). For example, Riebeck might expect a high degree of
disaggregation in available information (e.g. between the Amber and
Talc companies). A detailed review of gross profit margins by
European country may highlight those which require detailed
substantive procedures (tests of details).
Financial data (estimated June 2002) is already available for use at the
planning stage. Riebeck should have prior knowledge of the reliability
of such data (by considering how 2001s Actual compared with 2001s
Estimated).
As substantive procedures
Analytical procedures at this stage are optional. (Substantive
analytical procedures (SAPs) are based on the expectation that
relationships which are known to exist may be expected to continue in
the absence of clear evidence to the contrary. For example, the
relationship between gross profit and sales revenue may be expected
to remain constant unless there are changes in sales prices, sales mix
and/or cost structure.)
However, although the GP margin is almost constant for 2002 and
2001 it is unlikely that Riebeck would use this for substantive
purposes given:
- the diverse nature of operations in its industry;
- the multiple locations over which it operates; and
- the fact that it is known that unit revenues are falling (due to
market competition).
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(2) Many points can only be made as (and there is no relationship
between the two that would warrant a columnar approach). However,
some points could be made as either (or both) although the emphasis
would need to be different. For example, a matter to consider is the
audit program for the identification of related parties and
RPTs, whilst the evidence will include copies of extracts from minutes
and company registers and written management representation.
(1) Related party transaction sale of cargo carrier
(i) Matters
The cargo carrier was in use for 8/9 years and would have had a
carrying value of Kshs.720,000 at 30 September 2000 (assuming nil
residual value and a full years depreciation charge in the year of
acquisition and none in the year of disposal). Disposal proceeds
were only therefore Kshs.300,000 (say).
The Kshs.400,000 loss represents 15% of profit before tax and is
therefore material. Disclosure as a separate line item may therefore
be appropriate (IAS 8).
Abra appears to have a related party relationship with Aspersion as Iain:
is one of the key management personnel of Aspersion (being the
finance director); and
has an equity interest in Abra which is presumed to constitute
significant influence (being greater than 20%).
This relationship will be further strengthened/closer/more apparent if:
Iain is also a shareholder of Aspersion and/or a director of Abra;
any close members of Iains family are also shareholders of Abra
(being a private company).
The reason for the sale e.g. whether this aircraft was:
surplus to operating requirements (i.e. not being replaced); or
being replaced with a newer model (perhaps more likely as total assets
have increased by $600,000 during the year).
The reason for the loss on sale e.g. whether the:
sale was at an under-value (if the sale to the related party was not at
arms length);
aircraft had a bad maintenance history (or was otherwise impaired);
useful life of a cargo carrier is less than 20 years.
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Evidence of receipt of proceeds (e.g. vouched to cash at bank) and
direct confirmation from Abra of any amount outstanding at 30
September 2001.
Carrying amount (cost less accumulated depreciation) agreed to the
fixed asset register and recalculation of the loss on disposal. (Also,
purchase price agreed to prior year working papers, fixed asset
register, etc.)
A review of maintenance expenses and records (e.g. to confirm
reason for loss on sale).
Proposed wording for the note disclosure in the financial statements.
Written management representation that there were no RPs or RPTs
required to be disclosed in the financial statements other than those
which have been disclosed (completeness assertion).
Audited accounts of Abra (where available) showing tangible asset
additions of at least 12m.
(2) Impairment in light aircraft
(i) Matters
The annual depreciation charge for each of these two aircraft is
Kshs.30,000 (1/15 450,000). The aircraft have been depreciated
for only 2 years to 30 September 2001 (assuming time
apportionment in 1999 when the aircraft were brought into use)
and have a total carrying amount of $750,000 (2 [450,000 (2
30,000)]). This represents 72% of total assets (and some greater
% of tangible non-current assets) and is therefore material.
Tutorial note: Alternatively it could be assumed (though less
appropriate) that a full years depreciation was charged in the year
to 30.9.99 (i.e. three years accumulated depreciation to 30.9.01).
The aircraft were purchased for a specific use which will cease six
months after the balance sheet date. The value of the aircraft may
be impaired and Aspersion should have made a formal estimate of
their recoverable amount (IAS 36).
Whether management has estimated net selling price and/or value
in use.
Whether Aspersion prepares management accounts and budgets
and has experience in projecting cash flows (for determining value
in use). Managements intentions, for example:
- to sell the aircraft;
- to find an alternative use (e.g. providing other business or
pleasure flights).
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The amount of any impairment loss identified and whether or not it is:
- material (say Kshs.100,000);
- to be recognised in the financial statements.
Additional point
If the passenger business constitutes a business segment (IAS 14),
cessation of the contract may result in a discontinued operation (IAS 35).
(ii) Audit evidence
A copy of the service contract confirming expiry in March 2002.
Physical inspection of aircraft (evidence of existence and condition
at 30 September 2001).
Notes of discussions with Aspersions management concerning
negotiations for:
the sale of the aircraft; or
obtaining new service contracts.
Extracts from any correspondence.
A copy of any (draft) agreement for:
the sale of the aircraft after the contract expires;
new business or pleasure contracts.
Discounted cash flow projections for any proposed new
venture/contracts (i.e. value in use).
Comparison of projected cash flows with budgets and assumptions
(e.g. aircraft days available and average daily utilisation per
aircraft).
(3) Deferred tax change in tax rate
(i) Matters
The total provision amounts to 21% of PBT and is therefore
material. (However the deferred tax expense/income for the year
may not have been material.)
Under IAS 12 deferred tax is calculated on the temporary
differences between the tax base and carrying amount of assets.
The increase in liability if calculated at 34% ($570,000 (34/30
1) = $76,000) represents 28% of PBT. Considered in isolation, this
amount is not material.
The tax rate that should be used is the rate that is expected to apply
to the period when the liability is settled, based on tax rates that
have been (substantively) enacted by the balance sheet date (IAS
12). The increase in tax rate announced on 1 December is a nonadjusting post balance sheet event (IAS 10).
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2.
3.
4.
5.
6.
7.
8.
9.
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10. Should have built into the system a, mechanism for the system to
close down automatically if a wrong password is entered more
than 3 times.
11. Similarly it should close down it require the password to be keyed
in again if no activity takes place when the 2 machines are linked
for a period of time, say 5 minutes.
12. Should have built into the system a mechanism that informs the
mainframe computer the number of transfers to be effected so that
once many transfers have been effected the dial up link is
immediately disconnected.
b) The additional measures that Beeys Ltd. should take in order to
prevent unauthorized transfers:
i. Ideally the micro computer used at Beeys Ltd. to transfer funds
should be located in a secure office to which access is restricted
to only authorized personnel at approved times. This is the
normal lock and key. Ideally the computer should not be used
for another purpose.
ii.
iii.
iv.
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v.
Before any transfers are effected the invoices to be paid should be
subjected to a payment selection criteria. They should have
been supporting documents attached to them. A list should be
prepared and it should have the written authority for the
transfers to be effected in the form of a signature by the cheque
signatories and this list should be retained.
vi.
vii.
viii.
ix.
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linked through telephone lines. It is not unusual therefore for just
one contaminated machine to send out a wave of infection
spreading to thousands of other computers in a matter of seconds.
Therefore if the computer becomes linked to a network it stands
the risk of having its information corrupted should any of the
machines in the EDI network become infected. Any other
microcomputers within Beeys Ltd. can also be infected by the
interchange of diskettes between the microcomputers.
QUESTION FOUR
CLIENT: MACHO LTD YEAR ENDED 30th NOVEMBER 1993
MATTERS FOR THE PARTNERS ATTENTION
1. CHEQUES MAILED AFTER THE YEAR END
Cheques amounting to Kshs.661,180 were drawn on the last day of the
year and processed through the cashbook, creditors ledger and the
general ledger. The draft accounts have been prepared on the basis of
that general ledger. However these cheques were not mailed to the
payee until several days after the year-end. The draft accounts are
therefore reflecting that a payment had been made by the year-end
when the reality is that no payment had been made by then.
Consequently both creditors and cash at bank have been understated by
this amount i.e. Kshs.661,800.
2. USE OF THE WRONG PRICE LIST
A new price list which was to be effective on 1 st December was used in
November resulting in some customers being overcharged a total of
Kshs.1,140,230 A revealed by our credit tests. when management
became aware some time in December, an estimate in the amount of
kshs.650,000 was arrived at to account for the credit notes that would
subsequently have to be issued to the customers to correct the
overcharge. A provision against debtors was made in these amounts.
The account treatment of the poor bad debts was incorrect. Sales
should have been debited to reverse the overcharge. Turnover is
overstated by the whole amount of Shs.1,140,230 but debtors and profit
before tax are understated by the different of Kshs.490,230.
3. CAPITALISATION OF REPIAR ITEMS
Additions to plant and machinery during the year totaled
Kshs.3,380,000.
To verify the validity of these additions a
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6. UNINSURED RISK PROVISION
Several years ago an uninsured risk provision in the amount
Kshs.1,300,000 was set up to provide against unforeseen events yet no
amounts have been charged against it. This provision does not pass the
test of a liability. The provision is no longer required its inclusion in
credit is unwarranted and should be reversed to reserves.
QUESTION FIVE
DEXY
(a) Non-cancellable lease
(i) Matters
The principal issue is whether the lease payments should be:
- capitalised (as an asset) and amortised; or
- expensed as incurred.
IAS 17 Leases requires that a finance lease should be recognised
as an asset and a liability. Operating lease payments should be
expensed in the income statement on a straight line basis over the
lease term (or other systematic basis representative of the pattern
of benefits consumed).
Whether the non-cancellable lease is a finance or an operating
lease depends on its economic substance rather than its legal form.
Indicators of a finance lease are less likely to apply to this lease
than an item of equipment (say). For example, seven years of use
of a floor of a new office block development will certainly not be
for the major part of such an assets inherently long life.
Kshs.770,000 represents 21% of total assets. This is likely to be
considered material as the issue is whether this asset should be
recognised in its entirety, or not at all.
Whether Kshs.770,000 is the present value at inception of the lease
(as required by IAS 17 in determining the amount recorded as an
asset) or as calculated as at the balance sheet date (say).
The basis of setting the discount rate used to calculate the present
value if there is no rate implicit in the lease.
Kshs.130,000 represents 4% of profit before tax. Not expensing the
annual lease payment may, in isolation, be considered not material.
Also, as the impact on the income statement is off-set by
Kshs.110,000 amortisation plus finance charge, the net effect on
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If, after examining the evidence, it appears that the lease should
have been treated as an operating lease the auditors opinion
should be qualified except for for non-compliance with IAS 17.
(ii) Audit evidence
The suite of offices on the 13th floor that they exist and are used
by Dexy.
The contract setting out the lease terms to establish its legal form
(more likely to be an operating lease than a finance lease) and
interpret its economic substance.
The nature and amount of office expenditure incurred by Dexy in
respect of these premises, agreed to invoices, management charges,
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etc (to gauge to what extent the risks and rewards of ownership are
borne by Dexy rather than the lessor).
Recalculation of the present value of the minimum lease payments
(should be as at inception of the lease).
Recalculation of the pre-tax cost of capital of the discount rate used
(if there is no rate implicit in the lease).
Agree a Kshs.110,000 amortisation charge for the year to the
income statement.
Agree the completeness of disclosure of the minimum lease
payments. For example:
- Kshs.130,000 not later than one year;
- Kshs.520,000 later than one year and not later than five
years; and
- Kshs.130,000 later than five years.
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Artwork for the advertisements designed before the year end but
not placed until after the year end to confirm that the expense
incurred should be deferred to the next accounting period.
(c) Painting
(i) Matters
$135 million represents 37% of total assets per draft financial
statements (i.e. including revalued amount) and is therefore
material to the balance sheet.
Tutorial note: The impact on PBT is not assessed because it has no
impact on the income statement.
The painting is an asset i.e. a resource held by Dexy arising from
past events (a purchase) and from which future economic benefits
are expected to flow (e.g. when the investment is realised through
an eventual sale).
The asset has been held for 50 years and unless it is now held with
a view to sale should be classified as
non-current (IAS 1 Presentation of Financial Statements).
Managements future intention to hold or sell this asset, to
determine its classification as current or non-current.
Dexys going concern status and financial position. (Managements
intention could be to hold the asset but as it is not used in day-today operations it would be the ideal asset to dispose of to raise
finance.)
The painting is clearly not held for use in the production or supply
of goods or services. So unless it is held for rental to others or for
administrative purposes, it is not an item of property, plant and
equipment (as defined by IAS 16). It is therefore not subject to an
annual depreciation charge.
Whilst it was displayed in the reception office it may (arguably)
have been a furnishing for administrative purposes. However, as it
has now been removed outside of the business premises its
accounting treatment appears not to be covered by IAS 16.
There is no IAS dealing specifically with such assets held for their
investment potential.
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Tutorial note: Marks will be awarded for suitable points about placing
reliance on an independent expert valuer (e.g. to confirm the painting as
an original). However, candidates should be mindful of the cost of such
evidence and the availability of alternative evidence, as suggested above.
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MOCK FIVE
QUESTION ONE
A1. The Director
Computer Maintenance
Services Limited
P. O. Box ABC
Nairobi
Dear Sir,
We have commenced planning the audit of the financial statements
for the year ending 30 September, 1990. As already mentioned in our
letter of engagement dated 1 April 1990, our audit is designed to give
us in the main reasonable assurance that the financial statements give
a true and fair view as at the balance sheet date.
It therefore involves consideration of significant accounting policies
adopted by the company as to their suitability.
It is generally held that for an accounting policy to be suitable it must
be:i.
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Accounting for income at the date of the contract but charging
costs as they are incurred would imply that the company is not
matching revenue with related costs. Contract revenue is so
significant to the operations of the company that this policy
would seem to be imprudent as profits are likely to be over
stated.
ii.
For the financial statements to give a true and fair view we further
recommend that amount of contract revenue taken credit for any one
year be separately disclosed as a note for the financial statements, so
that the reader of the accounts can determine the uncredited reserve at
the beginning of the year, amount credited during the year, amount of
new contracts entered into the year, the balance at the end of the year
disclosed as unearned income.
Also the accounting policy note to the financial statements should
disclose this accounting policy.
In our opinion adoption of this policy will ensure that the accounts
present fairly the results from operations and the profits will not be
overstated.
Please do not hesitate to contact us for any clarification you may
consider necessary.
Yours faithfully
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Azure
(a) Audit planning issues
Tutorial note: Planning an answer means, as a minimum, deciding how
marks are likely to be allocated and structuring the answer accordingly.
In general, the more a question is broken down into parts, the less time
needs to be spent on formal writing out of an answer plan1. In this Q
there are clearly three specific matters to be addressed. However, there
are further explicit planning issues (audit risks and audit strategy
referred to in the second paragraph) as well as those implicit to planning
(e.g. materiality and logistics).
Risks
Inherent risk is increased at the entity level as the company operates in
geographically diverse locations. Also, the holiday industry is very
competitive and the collapse of major tour operators is not
uncommon.
Inherent risk is increased at the account balance and class of
transactions level because, for example:
- there are indicators of off-balance sheet financing (i.e. operating
lease commitments on aircraft);
- certain accounting policies may be imprudent (e.g. the point of
revenue recognition is holiday departure).
Revenue and profit may be overstated for holidays which commence
before the year end, but the costs of providing those holidays are
incurred after the year end. For example, an increasing number of
early retirees take long vacations commencing December (say) over
the winter months (January, February).
That cash and cash equivalents exceed non-current assets reflects
Azures exposure to liquidity risk. The company needs to maintain a
high level of liquid funds to meet its current liabilities (and operating
lease commitments).
Azures implementation of policies and procedures (e.g. in its internal
financial control system) suggest a risk-conscious management. The
control environment is likely to be assessed as strong which is crucial
if reliance is sought to be placed on internal controls.
The main financial risks likely to be faced by Azure are those
associated with foreign exchange and fuel costs (also possibly
interest rates).
Audit strategy
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Tutorial note: Although presented here as a general point, this could be
regarded as a conclusion and so appear at the
end of a planned answer.
A risk-based approach (either audit risk or business risk model) should
be adopted given:
- the emphasis on risk required for the submission (and the existence
of apparent risks);
- the likely need to rely on internal financial controls including the
internal audit function (e.g. for multiple locations);
- that it would be inappropriate to adopt certain standard tests of
detail (e.g. to confirm trade receivables by direct confirmation);
- the scope for analytical procedures in providing substantive
evidence.
Analytical procedures on quarterly/monthly (regular per Q) actual,
budgeted and prior year results may be used to effectively audit
Azures financial statements. For example, to review the
reasonableness of actual seasonality in turnover by a comparison of
budgeted and prior year amounts by location. Also, by proofs in
total, to confirm the reasonableness of:
- travel agency commissions
- depreciation (not aircraft, as leased)
- interest receivable on cash deposits.
Tutorial note: See also (3) below.
Materiality
Based on the 2000 accounts, preliminary materiality can be assessed to
be approximately:
Kshs.5m which lies in the ranges 1/2% 1% turnover and 1% 2%
total assets.
alternatively $27m which lies in the ranges 1% 2% total assets and
5% 10% PBT.
WORKINGS
1/2% 1% turnover 47m 94m
1% 2% total assets (at least 1091 + 297 + 1386 = 2774) 28m
55m
5% 10% PBT 14m 27m
Tutorial note: The assessment of materiality at the planning stage is its
quantification. A statement that preliminary
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Azures business strategy clearly includes investment in suitable
technologies which will help maintain/improve the companys market
position (and returns to investors) supporting the appropriateness of
the going concern assumption as the basis for the preparation of the
financial statements.
The changes in distribution methods are a source of actual and
contingent liabilities. If retail travel agents are closing, liabilities for
staff redundancy costs and onerous contracts (e.g. leases on premises)
may arise. Contingent liabilities may arise in respect of health and
safety issues (e.g. through non-compliance with regulations or injury
claims by employees).
During the transition from retail to direct sales methods, there may be
a duplication of costs (e.g. customers still want glossy brochures even
though they can look at their contents on the Internet) with a
consequent reduction in net margins.
(2) Internal financial control system
The audit of Azure should be more efficient if reliance can be
placed on a strong control environment (which will significantly
complement specific internal controls). The control environment is
likely to be assessed as strong if budgetary controls and the
internal audit function are shown to be effective.
Factors to be considered in assessing the effectiveness of budgetary
controls will include:
the frequency and timeliness of the review of budgets against
actual (monthly, quarterly?);
the action taken, if any, when actual is not as budgeted (e.g.
spiralling costs or slump in revenue at a location).
Factors to be considered when assessing the suitability of budgeted
information for analytical procedures include:
the degree of disaggregation (e.g. would expect revenues and
costs to be analysed between holiday location/hotel);
the availability of financial and non-financial data (e.g. nonfinancial might be expected to include air
passengers, passenger-kilometres, room occupancies, booking
cancellations, etc);
its relevance and reliability (e.g. if it is prepared with care).
The precise scope of the internal audit function will need to be
ascertained in planning an effective approach to the external audit
of Azure. Other factors to be considered in making a preliminary
assessment of the relevance and reliability of internal audit include:
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Azures exposure to liquidity risk. In particular current liabilities have
increased by Kshs367m (183%).
The 138% increase in advances is less than the increase in turnover.
This could be due to:
a fall in the level of advance bookings (e.g. as more
customers wait for last minute bargains);
Azure having relaxed its policy on the timing and/or
amount of holiday deposits and advance payments (e.g. to attract
bookings);
delays or other problems being encountered in
collecting deposits on Internet bookings.
The debt appears to have financed an increase in tangible non-current
assets and increased Azures liquidity in the short to medium-term. If
the debt is converted before its redemption date, Azure will have
increased its equity base and obtained finance for the longer term (e.g.
to meet increasing lease commitments of more than five years).
(b) Appropriate selection criteria
Tutorial notes
This part is perhaps easier than (a) in that it does not require the same
depth of analysis of the scenario. Candidates who strictly allocate their
time to each part are likely to score more highly on this question overall
than those who allow themselves to over-run on part (a) and produce
sketchy answers to (b).
The marking scheme indicates that full marks could be obtained by
identifying and briefly commenting on 10 criteria or identifying and
providing a more detailed commentary on just four criteria or anything
in between. This answer is indicative of the comments that could be
made, it is not prescriptive.
Audit firm
Background information provided by the audit firms invited to tender is
likely to include:
organisation structure (e.g. into specialised departments for audit, tax,
etc);
its size (e.g. in terms of staffing levels);
locations of offices (including overseas locations relevant to Azure);
affiliated firms (if any);
its relevant client portfolio (as an indicator of the firms relevant
experience and reputation in the travel/holiday/leisure industry).
Azure may be particularly interested in the reputation of the audit
firm (i.e. how highly it is regarded). For example, Azure may be
seeking to improve its standing/image (e.g. with its bankers or
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needs (for the benefits of onestop shopping such as economies of
scale).
Azure may be seeking an audit firm with a proactive approach and the
ability to add value to its business. For example, there may be tax or
other benefits to be obtained by changing the status and/or registration
of representative offices (e.g. from overseas branches to local
companies or vice versa).
Audit approach
In having requested, as part of the submission, principal audit risks
other planning issues audit strategy, Azure will expect the firms to
have demonstrated, for example:
a high level of planning
an understanding of audit issues (and how these issues will be
reported to Azure)
an audit methodology offering a cost effective approach.
Tax
Submissions will be expected to show an understanding of tax issues (e.g.
in relation to overseas operations) and proactivity in providing practical,
cost-effective solutions.
Chemistry
Although personal rapport and the audit firms enthusiasm for a working
relationship with Azure will be more apparent at the presentation stage,
Azure will make some assessment about chemistry before then. Azure
will be asking Do they understand our business issues? and if, for
example, Azure met with any of the firms before the submission Does
the submission show that they listened to us?.
Fees
Azure will expect competitive fees/value for money/constructive
business advice.
A fee breakdown (e.g. split between grades of staff and/or audit and
tax compliance work) will probably have been requested to facilitate
comparison between the firms.
Azure may be suspicious of (have reservations about) an audit fee
proposed by a tenderer if it is significantly lower (lowballing?) or
higher than others.
Other criteria
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ii.
A problem arises in the use of test packs in that there is a choice. The test
pack can be used
together with live input to test the effect of live programs, carrying out the
test during normal
processing using live master files. The alternative is to use copy, test or
dummy master files. The
choice is between live testing and dead testing.
(a)
If the data is included with normal data, separate test data totals
cannot be obtained. This can sometimes be resolved by the use
of dummy branches or separate codes to report the program's
effect on the test data.
ii.
iii. Client's files and totals are corrupted although this is unlikely to
be material.
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iv.
4 (b)
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ii.
2.
Disadvantages
1.
2.
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3.
4.
5.
v.
ISAs set out the basic principles and essential procedures that
auditors should follow in the conduct of an audit of financial
statements.
(ii) Auditing Standards are in bold type. The grey type found in ISAs
provides guidance on the application of ISAs.
(iii) International Standards on Auditing are set by the International
Auditing Practices Committee (IAPC) of the International
Federation of Accountants (IFAC). The IAPC is made up of
representatives of the profession who are members of IFAC.
(iv) ISAs and other documents issued by the IAPC are developed
using a process of exposure and consultation in order to obtain
consensus and wide-spread acceptance of standards. Consultation
is with interested parties outside the profession, as well as within
the profession itself.
(v) ISAs apply to all audits of financial statements that are expressed
in true and fair, fair presentation, or similar terms.
(vi) ISAs are developed with due regard for developments in national
standards as described in (c) below.
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(ii)
(iii)
(iv)
(ii)
(iii)
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(iv)
(v)
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QUESTIONS
This section has twenty questions and answers.
QUESTION ONE
The principal activity of Bateleur Zoo Gardens (BZG) is the
conservation of animals. approximately 80% of the zoos income
comes from admission fees, money spent in the food and retail outlets
and animal sponsorship. The remainder comprises donations and
investment income.
Admission fees include day visitor entrance fees (gate) and annual
membership fees. Day tickets may be pre-booked by credit card using a
telephone booking hotline and via the zoos website. Reduced fees are
available (e.g. to students, senior citizens and families).
Animal sponsorships, which last for one year, make a significant
contribution to the cost of specialist diets, enclosure maintenance and
veterinary care. Animal sponsors benefit from the advertisement of
their names at the sponsored animals enclosure.
BZGs management has identified the following applicable risks that
require further consideration and are to be actively managed:
(i) Reduction in admission income through failure to invest in new
exhibits and breeding programs to attract visitors;
(ii) Animal sponsorships may not be invoiced due to incomplete data
transfer between the sponsoring and invoicing departments;
(iii) Corporate sponsorships may not be charged for at approved rates
either in error or due to arrangements with the companies. In
particular, the sponsoring department may not notify the invoicing
department of reciprocal arrangements, whereby sponsoring
companies provide BZG with advertising (e.g. in company
magazines and annual reports);
(iv) Cash received at the entrance gate ticket offices (kiosks) may
not be passed to cashiers in the accounts department (e.g. through
theft);
(v) The ticket booking and issuing system may not be available;
(vi) Donations of animals to the collection (e.g. from Customs and
Excise seizures and rare breeds enthusiasts) may not be recorded.
382
Questions
Required:
(a) Describe suitable internal controls to manage each of the applicable
risks identified.
(12 marks)
(b) Explain the financial statement risks arising from the applicable
risks.
(6 marks)
(c) Comment on the factors to be considered when planning the extent
of substantive analytical procedures to be performed on BZGs
income.
(7 marks)
(Total: 25 marks)
QUESTION TWO
Harrier Motors deals in motor vehicles, sells spare parts, provides aftersales servicing and undertakes car body repairs. During the financial
year to 30 June 2004, the company expanded its operations from five to
eight sites.
Each site has a car showroom, service workshop and parts storage.
In May 2004, management appointed an experienced chartered
certified accountant to set up an internal audit department.
New cars are imported, on consignment, every three months from one
supplier. Harrier pays the purchase price of the cars, plus 3%, three
months after taking delivery. Harrier does not return unsold cars,
although it has a legal right to do so.
Harrier offers trade-ins (i.e. part-exchange) on all sales of new and
used cars. New car sales carry a three year manufacturers warranty
and used cars carry a six-month guarantee. Many used cars are sold for
cash.
An extensive range of spare parts is held for which perpetual inventory
records are kept. Storekeepers carry out continuous checking.
Mr Joop, the sales executive, selects a car from each consignment to
use for all his business and personal traveling until the next
consignment is received. Such cars are sold at a discount as exdemonstration models.
Car servicing and body repairs are carried out in workshops by
employed and sub-contracted service engineers. Most jobs are started
and finished in a day and are invoiced immediately on completion.
In May 2003 Harrier purchased a brand name, Uni-fit, which is now
applied to the parts which it supplies.
383
384
Questions
ratios stay within government specified limits. The entries are
then reversed at the beginning of the following month. The net
movement on these accounts over the year to 31 March 2004
was Shs.03 million.
(6 marks)
Required:
For each of the above issues:
i) comment on the matters that you should consider; and
ii) state the audit evidence that you should expect to find, in
undertaking your review of the audit working papers and financial
statements of Eagle Energy for the year ended 31 March 2004.
(Total: 20 marks)
Note: The mark allocation is shown against each of the three issues.
QUESTION FOUR
(a) Explain why quality control may be difficult to implement in a
smaller audit firm and illustrate how such difficulties may be
overcome.
(5 marks)
(b) Kite Associates is an association of small accounting practices.
One of the benefits of membership is improved quality control
through a peer review system. Whilst reviewing a sample of
auditors reports issued by Rook & Co, a firm only recently
admitted to Kite Associates, you come across the following
qualified opinion on the financial statements of Lammergeier
Group:
Qualified opinion arising from disagreement about accounting
treatment relating to the non-adoption of IAS
The management has not prepared a group cashflow statement and its
associated notes. In the opinion of the management it is not practical to
prepare a group cashflow statement due to the complexity involved. In
our opinion the reasons for the departure from IAS 7 are sound and
acceptable and adequate disclosure has been made concerning the
departure from IAS 7. The departure in our opinion does not impact on
the truth and fairness of the financial statements.
In our opinion, except for the non-preparation of the group cashflow
statement and associated notes, the financial statements give a true and
fair view of the financial position of the Company as at 31 December
2003 and of the profit of the group for the year then ended, and have
been properly prepared in accordance with
385
Your review of the prior year auditors report has revealed that the
2002 year-end audit opinion was identical.
Required:
Critically appraise the appropriateness of the audit opinion given by
Rook & Co on the financial statements of Lammergeier Group for the
years ended 31 December 2003 and 2002.
(10 marks)
(Total 15 marks)
QUESTION FIVE
You are a training manager in Hawk Associates, a firm of Chartered
Certified Accountants. The firm has suffered a reduction in fee income
due to increasing restrictions on the provision of non-audit services to
audit clients. The following proposals for obtaining professional work
are to be discussed at a forthcoming in-house seminar:
(a)
386
Questions
NOTE: The mark allocation is shown against each of the three issues.
QUESTION SIX
6 International Standard on Auditing ISA 240 The Auditors
Responsibility to Consider Fraud in an Audit of Financial Statements
distinguishes fraud from error, sets out the auditors responsibilities
with respect to fraud, and provides additional guidance related to
earnings management.
Required:
i)
Compare and contrast the auditors responsibility for the
detection and reporting of fraud and of error. Your answer should
distinguish fraud from error.
(5 marks)
ii)
Explain the term professional skepticism and comment on its
role in the detection of fraud.
(5 marks)
iii) Comment on the difficulties which earnings management
present to the auditor.
(5 marks)
(Total: 15 marks)
QUESTION SEVEN
PRACTICE ORGANISATION CHOICE
With the creation of new limited liability partnerships auditors now
have a choice of vehicle to deliver audit services. Explain the
advantages and disadvantages of:
(a) Partnerships
(5
marks)
(b) Limited liability partnerships and
(5 marks)
(c) Incorporated audit firms
(5 marks)
(Total: 20
marks)
QUESTION EIGHT
EXPECTATION GAP
The following statement has been made about the audit expectation
gap and the means of solving the problem.
387
388
Questions
(b)
Describe the issues that your firm might face in the provision of
internal audit services, in particular ethical concerns and how
these could be addressed
(4
marks)
389
(c)
3.
Required:
Comment on the ethical and other professional issues raised by the
above matters and their implications, if any, for staffing the final audit
of Isthmus for the year to 31 December 2002.
(Total: 15
marks)
QUESTION TWELVE
GAIS
390
Questions
391
392
Questions
(i) issuing new shares to the general public to provide funds for
the company, and
(ii) the three non-executive directors selling some of their shares
You are aware that Phones Anywhere has a number of very large
competitors, each of which has a large number of users and
comprehensive coverage (i.e. over 90% of the population are within
range of a relay station).
You are required, in relation to the audit of Phones Anywhere
(a) Consider the risks associated with the audit
(10 marks)
(b) Describe the ethical matters you should consider in deciding
whether your audit firm should accept the audit. This should
include considering whether your firm has the technical and
logistical ability to carry out the audit
(10
marks)
(c) Come to a conclusion on whether you would advise your firm to
accept or decline the audit, giving your principal reasons for
coming to this decision
(5 marks)
(Total: 25 marks)
QUESTION FOURTEEN
REGULATION AND PROFESSIONALISM
The auditing profession has been criticized recently by politicians for
its role in monitoring potential corporate failure. Radical reforms have
been called for in the way the audit is regulated. For example,
politicians have stated that there should be a change of legislation in
the following ways:
(i) Auditing standards
Auditing standards should be set and enforced independently from
the accounting profession
(ii)Fraud
Auditing firms should have a duty to detect and report fraud
(iii) Non audit services
Non auditing services supplied to an audit client should be stopped
(iv) The duration of the appointment of auditors
The appointment of auditors should be for a maximum of seven
years
393
Required:
(a)
394
Questions
Sales of the WAP phone, which now account for 80% of Alakazam.s
turnover, have recently started to fall. You have been assigned the task
of planning the audit of the financial statements of Alakazam for the
year ended 31 March 2002.
Required:
a) Describe the principal audit risks arising and how the audit strategy
will be directed to take account of them inthe overall audit plan.
(14 marks)
b) Mr Izzardo has now targeted Neodex, a private limited company, for
acquisition by Alakazam in early 2002. Your firm has just
completed a review of Neodex.s published financial statements for
the year to 31 December 2000 and held brief discussions with its
two directors. The main findings were as follows:
1) Shares in Neodex are owned equally by the technical director,
Stefan Koyla, and marketing director, Georgio Neratu, who set
up the company three years after graduating from university.
2) Neodex has successfully developed a small range of specialised
data interface network servers (DINS) which significantly
reduce the costs of communication systems. Each unit sells for
Kshs.3,500 . Kshs.5,000. Monthly sales are increasing slowly
but steadily since Georgio presented the products at an IT
exhibition earlier this year.
3) Between them, Stefan and Georgio assemble and package
DINS in a small rented office. The manufacture and assembly
of the principal component (a circuit board) is outsourced.
Stefan would like to recruit an assistant so that he has time to
prototype his new design for the Virtual Private Network (VPN)
market.
4) Neodex has only one employee who acts as telephonist,
receptionist, secretary and bookkeeper.
Required:
(i) Outline the principal matters to be considered by Alakazam in
deciding whether or not to acquire Neodex.
(5 marks)
(ii) Explain the implications of the acquisition for the conduct of your
audit of Alakazam for the year to 31 March 2002.
(6 marks)
(Total: 25 marks)
QUESTION SEVENTEEN
395
You are the manager responsible for the audit of Siegler, a limited
liability company. Siegler develops products and technologies for the
life sciences industry. The draft accounts for the year ended 30 June
2002 show profit before taxation of Kshs.46 million (2001 Kshs.42
million) and total assets Kshs.463 million (2001 Kshs.417 million).
The following issues are outstanding and have been left for your
attention:
(1) A government grant of Kshs.800,000 was received in May 2002 to
assist in operating a new pilot plant that will use Sieglers patented
bio-technology. The amount of the grant has been deducted from
bio-technology development costs that are included in intangible
assets with a carrying value of Kshs.45 million. In October 2002,
Sieglers order for specialist equipment, which was to have been
used in the pilot plant, was cancelled. A recent board minute shows
that the companys research activities are to be focused on a new
smart-drug technology.
(8
marks)
(2) Siegler closed and demolished one of its laboratories four years
ago. The land on which it stood has not been used since and is
carried at a cost of Kshs.72,000. Results of tests by the local
water authority published in July 2002 show that the site is
contaminated with hexavalent chromium, which is known to be
toxic. Although there is currently no legislation requiring Siegler
to clean up the site, a provision for $1 million has been made in
the financial statements for the year ended 30 June 2002.
(6 marks)
(3) Siegler owns two properties as well as its laboratories,
production facilities and head office. One property is a
residential apartment block and the other an office block. The
apartments are leased out on an annual basis and are currently
fully let. However, many of the offices are vacant and available
for let on monthly as well as annual terms. On 30 June 2002, the
apartment block was valued at an open market value that was
Kshs.33m in excess of its carrying amount under the benchmark
treatment of IAS 16 Property, Plant and Equipment (i.e. at cost
less accumulated depreciation). This excess has been credited to
a revaluation reserve.
(6 marks)
396
Questions
Required:
For each of the above issues:
(a) comment on the matters that you should consider; and
(b) state the audit evidence that you should expect to find,
in undertaking your review of the audit working papers and
financial statements of Siegler.
(Total: 20 marks)
NOTE: The mark allocation is shown against each of the three
issues.
QUESTION EIGHTEEN
You are the manager responsible for the audit of Visean, a limited
liability company, which manufactures health and beauty products and
distributes them through a chain of 72 retail pharmacies. The draft
accounts for the year ended 31 December 2001 show profit before
taxation of Kshs.183 million (2000 Kshs.124 million) and total
assets Kshs.184 million (2000 Kshs.127 million).
The following issues are outstanding and have been left for your
attention:
(1) Visean owns nine brand names of fragrances used for ranges of
products (e.g. perfumes, bath oils, soaps, etc), four of which were
purchased and five self-created. Purchased brands are recognised
as an intangible asset at cost amounting to Kshs.589,000 and
amortised on a straight-line basis over 10 years. The costs of
generating self-created brands and maintaining existing ones are
recognised as an expense when incurred. Demand for products of
one of the purchased fragrances, Ulexite, fell significantly in
January 2002 after a marketing campaign in December caused
offence to customers. (8 marks)
(2) In December 2001 the directors announced plans to discontinue
the range of medical consumables supplied to hospital
pharmacies. The factory manufacturing these products closed in
January 2002. A provision of Kshs.800,000 has been made as at
31 December 2001 for the compensation of redundant employees
and a further Kshs.450,000 for the three years unexpired lease
term on the factory premises. (7 marks)
(3) Historically the companys cash flow statement has reported net
cash flows from operating activities under the indirect method.
However, the cash flow statement for the year ended 31
397
December 2001 reports net cash flows under the direct method
and the corresponding figures have been restated. (5 marks)
Required:
For each of the above issues:
(i) comment on the matters that you should consider; and
(ii) state the audit evidence that you should expect to find,
in undertaking your review of the audit working papers and
financial statements of Visean.
(Total: 20 marks)
NOTE: The mark allocation is shown against each of the three
issues.
QUESTION NINETEEN
Aventura International, a listed company, manufactures and wholesales
a wide variety of products including fashion clothes and audio-video
equipment. The company is audited by Voest, a firm of Chartered
Certified Accountants, and the audit manager is Darius Harken. The
following matters have arisen during the audit of the group.s financial
statements for the year to 30 June 2001 which is nearing completion:
(1) During the annual physical count of fashion clothes at the
company.s principal warehouse, the audit staff attending the count
were invited to purchase any items of clothing or equipment at 30%
of their recommended retail prices.
(2) The chief executive of Aventura International, Armando Thyolo,
owns a private jet. Armando invoices the company, on a monthly
basis, for that proportion of the operating costs which reflects
business use. One of these invoices shows that Darius Harken was
flown to Florida in September 2000 and flown back two weeks
later. Neither Aventura nor Voest have any offices or associates in
Florida.
(3) Last week Armando announced his engagement to be married to
his personal assistant, Kirsten Fennimore. Before joining Aventura
in March 2001, Kirsten had been Voest.s accountant in charge of the
audit of Aventura.
Required:
Discuss the ethical issues raised and the actions which might be taken
by the auditor in relation to these matters.
(Total: 15 marks)
398
Questions
QUESTION TWENTY
(a) Explain the auditors responsibilities for reporting on compliance
with International Financial Reporting Standards (IFRSs) when the
financial statements state that they are prepared in accordance with:
i) only IFRSs;
ii) both IFRSs and relevant national standards or practices; and
iii) relevant national standards or practices, but which disclose in the
notes to the financial statements the extent of compliance with
IFRSs. (5 marks)
(b) You are the engagement partner to Frazil, a private limited liability
company. Frazils financial statements for the year ended 30
September 2003, show total assets Kshs.107 million and profit
before tax Kshs.82 million. The following matters require your
consideration:
i) The basis of accounting note states that the financial statements
have been prepared in compliance with International Financial
Reporting Standards. However, the accounting policy note for
development costs states that all development costs are expensed
as incurred. Results of audit tests showed that of the Kshs.37
million development costs expensed during the year, Kshs.14
million should have been recognised as an asset in accordance
with IAS 38 Intangible Assets.
ii) The management of Frazil has just informed you that, for the
first time, the annual report is to be published on the companys
website.
Required:
Identify and comment on the implications of the above matters for your
auditors report on the financial statements of Frazil for the year ended
30 September 2003.
(10 marks)
(Total: 15 marks)
399
ANSWERS
Tutorial note: These model answers are considerably longer and
more detailed than would be expected from any candidate in the
examination. They should be used as a guide to the form, style and
technical standard (but not length) of answer that candidates
should aim to achieve. However, these answers may not include all
valid points mentioned by a candidate credit will be given to
candidates mentioning such points.
ANSWER ONE
1 BATELEUR ZOO GARDENS
(a) Internal controls
Tutorial note: Remember that not all controls are preventive. Some
should detect (so as to correct) things that have gone wrong.
(i) Lack of investment
Monthly review and monitoring of:
- admission fees;
- number of day visitors;
- annual memberships taken out (analysed between new and
renewed);
- lapsed membership;
- sponsorship waiting lists (animals without sponsors and
sponsors waiting for suitable animals).
Approval of annual budgets which plan for adequate
investment to attract visitors.
Monthly comparison of actual expenditure on new exhibits
and breeding programs against budget to see the extent to
which the expected level of investment in development is
being made.
(ii) Incomplete data transfer
Monthly reconciliations of actual (invoiced) sponsorship
income to that expected (based on number of sponsorships,
400
Answers
401
402
Answers
403
404
Answers
405
406
Answers
407
408
Answers
409
410
Answers
411
412
Answers
413
Small firms and sole practitioners have the same access to a wide
range of technical and ethical advisory services provided by ACCA
(and other professional bodies) and should take advantage of these.
Small firms may work together as a consortium to share training
opportunities and sometimes staff. For example, an association of
small firms may adopt the same methodology and meet annually
(say) for technical updates.
(b) Lammergeier Group auditors report
The report is confused. It is clearly headed Qualified opinion
arising from disagreement yet the reasons for departure
(from IAS 7) are sound and acceptable. The heading is a
statement of disagreement, the latter a statement of
concurrence. If the auditor concurs with a departure the
opinion should not be qualified.
What is IAS 7? This should be stated in full, i.e.
International Accounting Standard 7 Cash Flow Statements.
It might be simpler/clearer to head the opinion paragraph
Qualified opinion arising from omission of cash flow
statement.
The auditors should not be expressing an opinion of
Lammergeiers management in their report. Managements
justification should be set out in a note to the financial
statements (e.g. in the accounting policies section). The
auditors report should clearly state that there is noncompliance with IAS 7. For example, As explained in note
the financial statements do not contain a cash flow
statement as required by IAS 7 [written out in full].
It cannot be true that the departure does not impact on the
truth and fairness . The requirement to prepare a cash flow
statement (and its associated notes) stems from the need to
provide users of financial statements with information about
changes in financial resources. If this information is omitted
the financial statements cannot show a true and fair view.
Except for [the non-preparation of the group cash flow
statements and associated notes] . is a qualified audit
opinion. This contradicts Rook & Cos assertion that the
matter does not impact on the truth and fairness .
If the departure from IAS 7 were justified it would assist the
user of the financial statements to know precisely where the
adequate disclosure has been made. If the auditor wished to
Answers
414
ANSWER FIVE
HAWK ASSOCIATES
(a) Cold calling
Tutorial note: Recognising that there are three issues to address (i.e.
cold calling, free and second opinions) is likely to earn more
marks than focusing on just one.
Until relatively recently cold calling has been largely
prohibited throughout the profession (and still is in some
countries e.g. Hong Kong). Therefore the direct approach may
not be suitable.
Where cold-calling restrictions have been relaxed it may still
only be permitted for existing business clients (i.e. to offer them
additional services), the direct approach to non-business clients
being prohibited. This inhibits competition.
Although the practice may be viewed as a bit grubby and
commercial it is now generally regarded as an accepted modern
business practice. Along with other professional bodies, ACCA
removed its prohibition on cold calling in 2002.
Whilst Hawk is permitted to cold call, the fundamental
ethical principles must be adhered to. Whilst solicitation
which is decent, honest and truthful may be acceptable, cold
calling which amounts to harassment is not.
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416
Answers
417
418
Answers
419
420
Answers
421
Advantages
It is a familiar structure and hence will appear trustworthy
Partners are taxed under the schedule D rules and hence there
can be advantages with the timing of the payment of tax
The amount of national insurance paid by a self employed
individual is lower and hence this can be advantageous
There is a reasonable amount of flexibility in structure
Disadvantages
There is joint and several liability hence you could be liable
personally for the negligent act of one of your partners
There is unlimited liability hence your personal assets are in
danger in the case of major litigation and/or liquidity
problems for the practice
The lower payments of national insurance can impact on
future state benefits for the partners
In many cases the lack of a formal partnership agreement can
cause problems in the case of a dispute and/or split of the
practice.
(b)
422
Answers
Disadvantages
The structure is new and hence many people may find it
difficult to trust
Although liability is limited there is still potential
exposure for individual partners
As a limited liability organization the business will have to
file accounts and hence certain information that was
generally private will be made publicly available
There is a possibility that the firm will need to have an
audit undertaken.
(c)
423
ANSWER EIGHT
EXPECTATION GAP
Key Answer Tips
Note here the requirements are highly specific and expect you to
focus on the practicality of the three proposals given. The question
is based to an extent on the widely discussed topic of to whom does
the auditor owe a responsibility?
A sensible structure for your answer might be to take each element
of the statement contained in the question and comment on it. Note
that you are expected to suggest your own proposals where you feel
the suggestions in the question are not practical.
A sound answer would, of course start with a summary of the main
implications of the Caparo decision.
(a)
Answers
424
(ii)
(iii)
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Answers
A further requirement of the Financial Services Act is that the
auditor has to report on these controls. Solicitors and estate
agents are covered by rules of their professional body over
clients money and the client accounts have to be audited by a
registered auditor.
So, for investment businesses there is a more erroneous audit
requirement than for companies.
Most company pension funds are not covered by the
Financial Services Act, but if the pension fund receives
investment advice (which is probable) the body giving this
advice is required to comply with the Financial Services Act.
I believe this requirement is unreasonable, as many investors
involve risk, with a chance that the value of investment will
decrease as well as increase (e.g. in 1991 the index of the
share price of the largest 100 firms in the UK (i.e. FTSE) fell
by 13%). If there was a requirement for no loss, all
investment businesses would have to make very safe
investments (e.g. in government fixed interest securities), and
this would not satisfy the requirements of any investors.
So, it is unreasonable ask the auditor to ensure that no loss
occurs on investments held by a financial institution.
However, there does appear to be a need for the auditor to
ensure that funds are invested in accordance with the wishes
of the investors that unauthorized investments are not made
and there is no fraudulent misappropriation of these funds, or
investment in funds with a view to committing a fraud.
Fraudulent misappropriation of funds may be relatively easy
to detect, but detecting investment in funds with a view to
committing a fraud is more difficult to detect. For instance,
the business may invest in a company (X Ltd) which is
owned by one of the directors of the investment company and
X Ltd is used to finance an expensive lifestyle for the
director. It may be difficult to detect who runs X Ltd and
whether it is likely to be a profitable investment.
A possible solution to this problem is to ensure that the
investment trust only invests in certain types of business (e.g.
companies quoted on the stock exchange) and that surplus
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Answers
429
ANSWER NINE
BECHER CONSTRUCTION
KEY ANSWER TIPS
This is a wide ranging question designed to test your knowledge of
basic aspects of corporate governance.
Easy marks are available here, but always, you must address the
question as set so plan your answer first. Note that part (a)asks
what and why you must deal with both. In part (b) jot down a list
of key issues as a wring before you start answering the question.
Part (c) requires you to understand the concept of an audit
committee and to deal specifically with its role in demonstrating
corporate governance- what do you think demonstrating here
means? Effective reporting is seen as a key feature of good
corporate governance draw on your financial and management
accounting knowledge.
Tutorial note: The question is aimed at testing the knowledge and
understanding of the candidate on corporate governance and the
roleof internal review. It requires a report therefore a report format
should be used sating out clearly the key messages in a logical
structure to meet the requirements set out and the audience being
addressed. This will be an area that the candidate will be expected
to keep up-to-date on the latest developments and best practice.
Report
To:
From:
Internal Auditor
Date:
xxxxxxxx
Subject:
430
Answers
(c)
431
(d)
Answers
432
ANSWER TEN
MT INVESTMENTS
______________________________________________________
_______________
Key answers tips
This question focuses on practical ethical issues involved mainly
in the context of outsourcing. Do not be put off by the question
being set in the context of an investment company it is quite
433
likely that this had no major impact on the approach you will
take to the answer.
Note that a favourite word of auditing examiners appears more
than once in the question the word issue, usually meaning
factors to consider in a given situation before making a decision.
Report
(a)
To:
MT Investment
From:
External Auditor
Date:
xx/xx/xx
Subject::
services
(i)
(ii)
Risk coverage
The level of service to be provided needs to be clearly set out,
through an evaluation of the audit universe and risks to the
company. Effective high level planning is critical to the
success of any internal audit service and should include:
Identification of key risks
Frequency of audit review
Justification of any plan
Discussion with senior management on their
understanding of risks.
(iii)
Answers
434
(v)
(vi)
Corporate Governance
The internal audit function has a key role to play in corporate
governance, in particular in assessing the level of risk
exposure and how controls are being managed. Information
on corporate governance can be obtained in a number of
ways, ranging from the regular communication with
management, internal audit reports, ad-hoc reviews and
potentially corporate governance and risk workshops or
surveys.
(b)
Issues faced
The ethical issues have been particularly in prominence
recently, with a body of opinion saying that external auditors
should not undertake internal audit services because of the
potential for conflict of interest and the obvious threat to
independence. External auditors may be in a position of
reviewing the service provided by internal audit which is in
effect a review of itself. This may inhibit both the role of
internal and external audit.
Ways around this include:
435
ANSWER ELEVEN
ISTHMUS PLC
Answers
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437
(2)
Shares inherited
Ethical and professional issues
A self interest threat has arisen as Mercedes has a direct
financial interest in Isthmus (i.e. she controls the shares). In
particular, in wishing the share price to increase Mercedes
might be in a position to overlook unrecorded liabilities and
losses discovered during the conduct of the audit (say).
Even though Mercedes may have independent of mind and be
known to act with the utmost integrity, she cannot have
independence in appearance.
This inadvertent violation (i.e. through inheritance) of an
independence principle does not impair the independence of
Kloser or the audit team providing:
- Klosers established policies and procedures have
resulted in Mercedes having reported promptly her
inheritance of the shares.
- Kloser promptly advises Mercedes that the shares should
be disposed of; and
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Tutorial note:
If he committed such an act he should be
instantly dismissed by the firm and any professional body under
which he is registered (e.g. ACCA)notified for disciplinary action.
However, if he in some way communicated (e.g. in a careless
remark) something that prompted his father to sell the shares, he
may be in breach of his duty of confidentiality. This should be
investigated and appropriate action taken (e.g. he may be
cautioned or given a written warning).
If he unknowingly gave his father price sensitive information,
then his father may be guilty of insider dealing (or similar) for
having acted on it.
Implications for staffing
Unless there is any reason to suppose that Anthony has acted
improperly (e.g. if he has delayed disclosing the matter) here is
no reason why he should not continue his position in the audit
team.
However, if his father were to come under suspicion of insider
dealing then Anthony should be withdrawn from his assignment.
Overall
Given the high profile attaching to this listed client it would be
timely to have all members assigned to the audit team renew their
written declarations of independence and confidentiality.
ANSWER TWELVE
GAIS
Key answer tips
This question relates to the practical application of best practice
and technology to effective practice management. You should
carefully read the question and ensure that you provide appropriate
recommendations and explanations, with supporting examples.
Part (a) requires you to explain the benefits of technology and to
make specific recommendations on use within GAIS audit services.
Automation is a continuing trend and you should reflect the
changing and developing nature of IT.
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Benefits of technology
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Quality control
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(iii)
(iv)
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(v)
(vi)
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(ix)
(x)
(xi)
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material misstatements in the financial statements, which
increase the risk of litigation being brought against me)
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very low fee (often called low balling) in order to obtain audit, as
this would impose pressure on the time allowed to carry out the
audit. This could lead o inadequate work being carried out which
would increase the risk that material misstatements in the financial
statements may not be detected.
Other matters covered by the rules of Professional Conduct
include:
(i) When my audit firm is asked to accept the audit appointment, I
must ask the clients permission to communicate with the
existing auditor. If this permission is refused, my audit firm
should decline to accept appointment as auditor.
(ii) My audit firm should write to the existing auditor requesting
all the information which ought to be made available to decide
whether or not to accept the audit appointment.
(iii) My audit firm should consider the reply from the existing
auditor. If adverse comments are made by existing auditor, I
will have to consider whether to accept the audit appointment.
(iv) If the existing auditor does not reply t my firms letter, a
further letter should be sent giving notice (e.g. seven days) that
no reply is received in that time, it is understood that there are
no professional or other reasons preventing my firm form
accepting the audit appointment.
(v) Before finally accepting the audit, my firm should prepare a
letter of engagement and ask the directors of Phones
Anywhere to sign it.
(c) From the discussions above, my firm should not offer itself
nor accept the appointment as auditor of Phones Anywhere.
The main reasons for this decision are:
(i) Phones Anywhere appears to be too large a company for my
firm to audit, and if is likely to grow faster than my audit
firm. The audit fee will probably exceed the limit of 15% of
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the practice income, and if this is not exceeded now, it is
likely to be exceeded in the next few years.
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Each Recognized Supervisory Body adopts auditing
standards in order to meet the Companies Act
requirement, and each body is required to have
arrangements in place for the effective monitoring and
enforcement of compliance with those standards. Failure
to apply relevant auditing standards is a factor which an
RSB will take into account when deciding whether
persons are fit and proper to be eligible for appointment as
company auditor.
ii)
iii)
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The argument put forward is that the consequences of
auditing affect society and therefore in order to ensure that
audits achieve social goals, auditing standards should be
set by an independent body.
ii)
iii)
(v)
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Risk assessment
The auditor considers e-commerce business risks in so far as they
may impact on audit risk including:
- risks arising from relationships with e-commerce trading
partners this concerns the authenticity of customers/supplies
and the integrity of transactions;
- risks related to the recording and processing of e-commerce
transactions e.g. if an unidentified individual can initiate a
transaction, or there is a loss of visible evidence (audit trail);
- pervasive e-commerce security risks (including viruses, hacking
and other computer crimes) which impact on the control
environment;
- denial of service i.e. overloading the system with spoof orders
to bring down the system;
- fraud risks which are increased by the anonymity of customers
(similarly money laundering);
- risks of system failures or crashes which restrict access and
result in loss of data;
- enhanced going concern risk of companies involved in Internet
activity generally and dot.com companies in particular.
The way in which an entity uses IT for e-com, including the entitys
assessment of risk and acceptable risk levels in the IT systems, is
significant to the security, completeness and reliability of the
financial information produced, and therefore affects the auditors
assessment of inherent and control risk.
Dot.Com entities
Particular risks relating to dot.com entities include:
- the absence of a traditional asset base;
- the treatment of costs incurred in setting up an infrastructure;
- the need for on-going investment in web technology;
- cash flow forecasts and business plans based on subjective
judgments without any proven basis;
- lack of cash flows when business takes off (i.e. over-trading);
- generating intangibles such as brand value and customer
service quality;
- market pressures to achieve expectations;
- value added through e-commerce resulting in a market
capitalisation
which
is
significantly
(sometimes
phenomenally!) higher than the book value of the underlying
net assets.
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Systems failures
Systems failures (both at the entity and for outsourced functions)
can affect the entitys reputation and result in a potential loss of
customers, with a significant impact on profit. The auditor considers
the entitys contingency and business continuity plans.
Evidence
In contrast to traditional businesses which focus on controls relating
to each stage of transaction recording, system controls for ecommerce focus on transaction execution (e.g. fulfilling a customer
order). The auditor must obtain evidence of both the design and
operation of controls relating to transaction execution to ensure that:
- fictitious or multiple identities are identified (i.e. authentic
customer);
- customers browsing and those placing orders are distinguished;
- input is validated and duplication or omission of transactions is
prevented;
- terms of trade are determined at the same time the
order is processed (this may require that payment is
collected when an order is placed);
- causes of transaction failures (e.g. credit card
authorisation failure and breaks in communication) are
addressed;
- incomplete processing is prevented (e.g. by rejecting
the order).
It is highly unlikely that a round the computer approach will be
appropriate as both input of transactions and processing are
electronic. Even though physical goods may be dispatched (though
not always e.g. software suppliers) there is typically less
conventional external audit evidence and the traditional audit paper
trail is virtually eliminated (e.g. on-line customer orders and
confirmation thereof).
Audit trails including access and transaction logs may deter and
detect unauthorised users and rogue transactions. Although entities
may not have automatic access to these and other unusual activity
logs, service-level agreements with the ISP (Internet Service
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Intangible assets
Intangible assets and profit for the year may be overstated in respect
of any carry forward of distribution rights capitalised last year.
Amounts involved are likely to be material and management will
probably be biased in favour of carry forward (e.g. amounting to
6/24 cost). This will be imprudent if, for example, future sales of
the WAP phone are in doubt and the value of distribution rights is
impaired.
Conclusions
Inherent risk is high as the financial statements may be materially
misstated due to the likelihood of errors arising and the high degree
of subjectivity involved regarding accounting matters (going
concern, warranty provisions, inventory valuations, intangible
assets, etc).
Control risk is likely to be low in some areas (e.g. purchases) but
potentially higher in others (e.g. inventory).
To render detection risk low will require a substantive approach to
the higher risk and judgemental areas (e.g. inventory valuation,
warranty provision) though reliance will be placed on controls if
appropriate (e.g. purchases and payroll).
Additional point
Foreign currency exchange risk arises on imported goods.
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costs incurred by the servicing department after the year end for
phones sold prior to the year end.
It is likely that the client will not have much experience in
exercising judgement in this area and may therefore be looking for
guidance. Reliance on management representation, as to the
adequacy of the provision, may therefore be inappropriate.
Legal advice
Communication with the companys legal adviser and possibly,
also, an independent lawyer should be established as specialist
evidence may be required in respect of:
- the legal interpretation of the agreement with the manufacturer
especially regarding the defects;
- the legal interpretation of the conditions of sales warranty;
- legal opinion on the outcome of any litigation with the
manufacturer or customers.
Bank/loan creditors
Confirmations will be required, so details of the companys bankers
and other providers of finance must be ascertained in good time
before the year end. Specifically, care should be taken to ensure that
information is obtained on the following:
- title deeds held (e.g. to head office premises);
- dates planned for review/renegotiation of facilities;
- bills of exchange, letters of credit or other means of settling
amounts due to the overseas supplier.
Discussion with management
Matters to be discussed with management include:
- developments in financing negotiations;
- basis of preparation and assumptions used in forecasts;
- whether Alakazam is involved in any litigation.
Assuming that there is no conflicting evidence that contradicts
management.s representations, it may be appropriate to obtain
written management representations.
Additional points
Substantive procedures on the inventory valuation should be aimed
at ensuring the adequacy of the provision for slow moving, obsolete
and faulty items.
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A hot review of the audit files should be scheduled given the high
inherent and failure (i.e. going concern) risks associated with
Alakazam.
(b) Proposed acquisition of Neodex
(i) Matters to be considered
Tutorial note: As the requirement did not specify the nature of the
principal matters to be considered (e.g. financial, operational,
strategic) there is a lot of scope for just 5 marks. What is important,
is that they should be matters considered by the acquiring company.
Whether the planned .acquisition. is:
for a controlling interest or 100% ownership;
of Neodex.s shares, its business or its assets (see below).
(Consolidated group accounts will have to be prepared if Neodex
is acquired as a subsidiary.)
The eagerness of the two parties to proceed with the
negotiations. Alakazam is the company making the moves to
acquire Neodex and the directors of Neodex may therefore have
the .upper hand. in negotiating an acceptable offer price.
Stefan and Georgio are relatively young and perhaps lacking in
business acumen. Stefan, in particular, may be keen to see the
DINS exploited by Alakazam for a faster and greater return than
they could achieve on their own.
What is it that Leon Izzardo is trying to acquire for Alakazam?
One motive for the acquisition is likely to be the DINS (and
possibly Stefan.s new design). To secure new designs, the
expertise of Stefan must be retained (e.g. by offer of share
options) and motivated (e.g. by profit-related pay).
Agreement must be reached with both shareholder-directors to
acquire (at least a controlling interest in) the company. To buy
all Neodex.s shares, the same offer may need to be made to both
directors.
Stefan may perceive his shareholding to be the more valuable
(because of his intrinsic value to the company as the
technical/design director). The offer to Stefan could be
differentiated from that to Georgio Neratu by leaving Stefan with
a shareholding.
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ANSWER SEVENTEEN
3 SIEGLER
Tutorial notes
(1) Matters will often encompass considerations of risk,
materiality and accounting treatment(i.e. the omission of
recognition and/or disclosure as well as benchmark and
alternative treatments).
(2) Many points can only be made as either matters or audit
evidence (and there is no one-for-one relationship between the
two that would warrant a columnar approach). However, some
points could be made as either or both although the emphasis
would need to be different. For example, a matter to consider in
(1) is the terms and conditions of the grant which may provide
evidence of the likelihood of the grant being repaid, whilst the
evidence will be documentation to and from the government (e.g.
grant application form or contract).
(1) Government grant
(a) Matters
The grant represents 174% of profit before tax, 178% of
intangible assets and 17%
of total assets and is therefore material. Intangible assets
(before deduction of the grant) constitute 97% of total assets and
are therefore material also. Receipt of a grant does not itself
provide conclusive evidence that any conditions attaching to it
have or will be fulfilled.
The most appropriate accounting treatment of the grant depends
on whether or not
it:
relates to asset(s) or income;
has been made for past or future expenditure;
has (or will) become repayable.
If the grant related to assets it should be presented in the balance
sheet either as deferred income or by a deduction from the carrying
amount of the assets. A grant relating to income should be credited
to the income statement (IAS 20 Accounting for Government
Grants and Disclosure of Government Assistance).
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The terms and conditions of the grant set out in the application
for the grant or government contract received including:
- pre-conditions (e.g. if Siegler was to have already placed
an order or contracted for the specialist equipment before
being entitled to receive the grant);
- any proofs of purchase or similar which may be required
to be sent to the government agency as and when
expenditure is incurred;
- any obligations of Siegler to declare any breach in their
undertakings.
Correspondence with the relevant government agency (e.g. if
repayment of the loan has been requested).
Any penalties incurred, and by whom, as a result of the order
for specialist equipment being cancelled.
The repayment, if any, of part or all of the grant since 30 June
2002.
Legal advice on the terms and conditions of the grant and
whether, for example, repayment can be enforced.
Management representation confirming future plans for
Sieglers activities.
(2) Contaminated land
(a) Matters
The cost of the land represents 16% of profit before taxation and
less than 02% of total assets and is therefore not material (e.g. if the
value of the land is so impaired that an impairment loss should be
recognised amounting to the whole of its cost).
The provision represents 217% or profit before taxation and 22%
of total assets and is therefore material.
The reason for the closure and demolition four years ago whether
Siegler knew about or suspected the contamination.
The reason for recent testing by the water authority (e.g. whether
routine inspection or in response to concerns about public health
and safety).
A provision should not be recognised unless there is:
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However the objectivity of the prior year audit may have been
impaired if Kirsten already had a personal relationship with
Armando before she joined Aventura and while she was still
employed by Voest. On being made aware of the relationship (even
if it was only last week) the engagement partner/Voest should have
arranged for a .cold. second partner review of the audit working
papers for the prior year. If there is any possible lack of evidence in
respect of a material area, the audit program for the current year
should be reviewed and amended (as necessary).
As the former AIC, Kirsten may have close relationships with the
audit team conducting the current year.s audit. However, the audit
team should have been adequately briefed and be alert to the
possibility that she could influence them, however unwittingly (e.g.
in simply explaining how she .did things. previously). The extent to
which reliance (if any) has been placed on any representations by
Kirsten should be reviewed in the light of the announcement.
The audit engagement partner should review the audit strategy (e.g.
in terms of its predictability) to ensure that Kirsten.s previous
knowledge of it (presumably passed on to Armando) will not impair
its effectiveness.
ANSWER TWENTY
FRAZIL
(a) Auditors responsibilities for reporting on compliance with
IFRSs
It has long been established that:
the auditors principal responsibility for reporting (generally) is
to express an opinion on whether the financial statements are
prepared, in all material respects, in accordance with an
identified financial reporting framework (ISA 200 Objective and
General Principles Governing an Audit of Financial
Statements);
the auditors report must clearly indicate the financial reporting
framework used to prepare the financial statements (ISA 700
The Auditors Report on Financial Statements). Specifically,
auditors responsibilities for reporting on compliance with
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IFRIC interpretation.
IAS 38 Intangible Assets requires that development costs which
meet all the specific criteria (e.g. technical feasibility) for asset
recognition MUST be recognised as an asset and not expensed.
Tutorial note: The question does not call for the regurgitation of
those criteria.
Total development costs expensed during the year represent 45% of
reported profit before tax and are therefore material.
The Shs.14 million which should have been capitalised represents:
13% of total assets;
38% of development costs incurred during the year; and
17% of PBT.
Although clearly material to PBT it is not particularly material to
the balance sheet. However, this is only the amount which should be
capitalised for the current year. If not adjusted for this year, it would
be an unadjusted error, the cumulative effect of which should be
considered in the subsequent year.
Therefore, as there is clearly non-compliance, which is material, the
financial statements do not comply with IFRS.
Management should be asked to:
increase intangible non-current assets by Shs.14 million;
reduce development expenses by Shs.14 million (thereby
increasing profit to Shs.96 million);
change the accounting policy note for development costs to state
that an asset is recognized when certain criteria are met.
In the absence of which the audit opinion should be qualified
except for disagreement unless the assertion of compliance with
IFRS is deleted.
Tutorial notes:
(1) As there is no reason to suppose that the prior year policy was
other than to expense as incurred, there is no brought forward
balance and IAS 38 transitional provisions are not retrospective.
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